In this second part of our two-part series on wrong net asset values (NAVs), we go beyond last week's column on what causes wrong pricing to explore what a fund does when it just can't get the NAV right.

Security pricing errors that occur within the fund accounting or operational areas of a mutual fund aren't much fun. But the necessity for making individual value judgments on the prices of a thinly traded, exotic, or illiquid securities can present its own set of challenges, and is a second error checkpoint.

When a catastrophe, such as an earthquake, rocks and temporarily closes international exchanges sometimes forcing them to temporarily close, determining security prices can be downright painful.

When the closing market price of a security is not readily available, or cannot be readily determined, or an event takes place after the close of a market that would ordinarily be expected to impact the price of that security, a fund advisory company is expected to go into quasi-crisis mode and begin the process known as "fair value pricing."

Getting Your Fair Value's Worth

Fair value pricing refers to determining the price at which a fund might reasonably be expected to receive upon a current sale. No single prescribed standard exists. The process is more of an art than an exact science and can include several methodologies that differ from complex to complex and even fund to fund within the same complex.

Nevertheless, the SEC has made it clear that it will be continually checking over fund advisers' shoulders to ensure that fair value pricing procedures, which must be blessed by a fund's board of directors, is being correctly implemented.

"We will be looking at the use of fair value pricing procedures and any changes to [such] procedures adopted by fund boards," said Lori Richards, director of the SEC's office of Compliance Inspections and Examinations at a conference this past April.

"Valuation, it seems, is one of the crucial areas in which investors must feel comfortable that they can trust a fund's managers and board of directors," noted Paul Roye, director of the SEC's Division of Investment Management, speaking at an industry conference this past March.

In 1999, and again in 2001, the SEC released guidance on tackling pricing issues related to mutual funds' securities. Since then, it appears that many fund companies have been busy bringing their own pricing procedures into compliance, to keep regulators at bay and avoid pricing snafus that can trickle down to variances in a fund's net asset value (NAV).

What's more, while a fund group's board of directors doesn't have day-to-day responsibility for pricing securities, it does have oversight for the methods used to best determine fair value prices. And board members have been minding that process more carefully than ever before. "Fair value pricing committees are much more active than three or four years ago," said Jeff Shiverdecker, SVP of business services with BISYS of New York.

Taking the SEC's Cue

A recent survey of mutual fund companies conducted by Deloitte & Touche of New York, found that 75% had changed their approach to fair valuation as a result of the SEC's guidance.

"Appropriate security valuations continue to be a cornerstone of the asset management industry and represent a significant day-to-day responsibility and challenge for fund management," said Paul Kraft, a partner with Deloitte & Touche's investment management services group and co-author of the study.

The study found that larger firms tended to put more resources into and spend more time evaluating and revising fair valuation pricing policies, Kraft added. It also found that 81% of funds now have formal metrics and policies in place to deal with "significant events" such as when significant market fluctuations occur.

In an April 30, 2001 letter to the Investment Company Institute, the SEC cautioned fund advisers to watch for foreign market volatility. Since many foreign markets open and close several hours ahead of U.S. markets, the closing price on a foreign security can be as much as 15 hours old by the time U.S. funds calculate their NAVs, the SEC warned. If a "significant event" should occur after the close of a foreign market, but before a fund's NAV has been determined, that security price could be inaccurate. That could result in the fund's NAV also being inaccurate, creating a windfall for redeeming investors if the NAV is too high, or creating a short-term trading opportunity for arbitrageurs if fund shares are priced too low.

When it comes to pricing a fund's NAV, a mistake is a mistake whether the error occurs within a fund's back office or based upon a poor fair valuation effort. If the error is significant enough, the SEC may seek details to better understand what cog in the system broke down, or even pursue enforcement action. Either way, the end goal is to correct the error and make any disadvantaged fund investor whole. And the party at fault is expected to pony up any loss.

To that end, in 1997, the ICI issued a flow chart to map out how fund advisers should correct NAV errors. Remedial action depends upon the magnitude of the error. If the error is less than or equal to one cent per share, the mistake is considered immaterial and corrective action is unnecessary. If, however, the error is greater than 1/2 of one percent of the fund's NAV, remedial action, including adjusting investor accounts and making whole investors who had redeemed, may be required depending upon whether the NAV was overstated or understated.

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