To err is human, to forgive divine. But when errors occur in mutual fund net asset values, they can be problematic and a source of frustration.

In recent years, both Heartland Funds of Milwaukee and Van Waggoner Funds of San Francisco have run into serious trouble over alleged mispricing of their funds' securities, which eventually led to huge downward repricings of the funds' net asset values (NAVs) and shareholder lawsuits. In 1999, Investment Advisors, Inc. of Minneapolis found itself embroiled in a lawsuit because of questionable valuations related to two privately held securities in one of its funds.

Errors in the pricing of mutual fund portfolio securities can cause problems, especially if they are significant enough to have a consequential impact on the pricing of a fund's NAV above a one-cent change. Industry-wide automation has largely assured that errors don't occur very often. Controls built into both securities valuation software and NAV calculation programs often send up red flags, alerting users that something is amiss or needs to be reevaluated.

"NAV errors are much less common today than 10 years ago because the controls are better," said Peter Muldoon, director of client services at Global Investment Systems of Hackensack, NJ. While the human element is still very much a part of the process, more and more checks and controls have been initiated where trouble spots once existed, making errors much less likely, he added.

Bring in the Accountants

What ingredients go into that all-important daily calculation of each fund's net asset value? To determine that NAV, internal or external fund accountants must first price all of the securities in a portfolio, then crunch the numbers to account for the fund's share of expenses incurred, accounting for any expense cap limitations, then add back interest or dividends accrued on those securities.

Securities' pricing is the main component of NAV calculations, and the first error checkpoint. Mistakes can most easily occur here for several reasons. Sometimes an error is due to one of the securities prices being incorrect. But errors can also occur where the share amounts reflected in the fund differs from the amount reflected in the fund accountant's records, said Matt Sadler, president and CEO of Quintara Capital Management of Piedmont, Calif.

Occasionally, a fund accountant will incorrectly transcribe the trading symbol of a security, having the price for that erroneous security get figured into the calculation mix, he said. That can be most problematic if the price difference between the two securities is significant, or where a fund owns a large position in a particular security.

Fund managers or administrative staff are the ones responsible for telling the fund accountants what securities have been bought and sold for a fund within one trading day, said Mark Seger, managing director of Ultimus Fund Solutions of Cincinnati, Ohio. Automatic data feeds are most typical and usually translate into fewer errors, but some small funds still relay that information by fax. Mistakes can happen just by virtue of the huge volume of transactions that are handled, although the percentage or errors is low, he said.

As far as errors in the pricing of each security in a portfolio, most funds use an independent securities pricing service to provide accurate daily prices. Some service providers will then automatically run all securities by a second pricing service to double check price accuracy, said Jeff Shiverdecker, SVP, business systems in the Columbus, Ohio office of BISYS of New York.

Most pricing systems automatically spit out "tolerance reports" that kick out individual securities if prices have changed outside of a specified volatility range from the previous day, or where some other error is suspected. For equity securities, more than a 10% price difference will usually require further investigation, but for fixed-income securities, the tolerance is only 1% or 2%, Seger said.

"If we try to enter a price with a big difference, the system will kick out warnings," agreed Dale Smith, SVP of BISYS' financial services group.

Corporate actions, such as a stock split, can often be the culprit of a pricing quandary. If, for example, a stock splits two-for-one, the share price will fall by 50%, flagging the stock's price for further investigation. "Corporate actions used to cause a lot of problems," said Shiverdecker of BISYS. But today, many corporate actions are announced a month in advance, giving fund accountants plenty of time to anticipate changes, he added.

As a safety valve, it can also make sense for a fund accountant to take a big-picture look at the relative changes in the NAV of a fund from day to day, as compared to the index or benchmark the fund most closely compares itself to, said Seger of Ultimus. If the Nasdaq is up 5% from yesterday, but a usually volatile tech fund is only up 1%, the disconnect may signal an error, he said.

Subscribe Now

Access to premium content including in-depth coverage of mutual funds, hedge funds, 401(K)s, 529 plans, and more.

3-Week Free Trial

Insight and analysis into the management, marketing, operations and technology of the asset management industry.