Stock exchanges in the United States are open, when those in Asia and Europe are closed.
So how will a U.S. mutual fund manager price stocks in foreign markets by 4 p.m. New York time, to get a value on a complete portfolio?
The answer: Act as though all the markets are open. The key: Use sophisticated pricing tools to arrive at an estimate of a stock's price when the foreign exchange opens the next day.
That is the essence of a new method of stock valuation known as fair-value pricing. The approach isn't an exact science-there are differences between how often the process is used and what methodology is used.
Historical patterns have to be used to figure out what impact different events might have on a security, after a market closes, and how that will affect the price when trading reopens. Each security has its own adjustment factor and typically a "confidence level" has to be ascribed to the probability that the adjustment will be accurate. But, in some fashion or other, the methodology is being used by just about every mutual fund based in the U.S.
A study from Interactive Data, a reference data and evaluations firm headquartered in Bedford, Mass., shows that about 36% of U.S. fund managers use fair value pricing on their securities each day. The other 64% use it only under certain circumstances. Either way, it's getting used.
"The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities," said Robert Haddad, director of evaluated services for Interactive Data. "Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing."
Interactive Data is one of two third-party providers of fair value pricing for non-U.S. securities. The other is Investment Technology Group (ITG), which is also well-known as an agency brokerage.
The reason fair value is needed: Time differences otherwise make it possible for traders to earn profits for their firms, at the expense of long-term holders of shares. They know that international markets often move in sync with U.S. markets. Based on how U.S. markets close, they buy or sell a U.S. mutual fund that holds international stocks.
Asian or European markets close as many as 15 hours before the U.S. trading day ends. If a piece of news buoys a stock or U.S. trading as whole, foreign stocks typically will react by rising at the start of the next trading day. Funds invested heavily in Asia-Pacific securities are the most affected by fluctuations in the U.S. market.
"It has some effectiveness but it is the most effective when combined with redemption fees and internal monitoring of who is buying and selling shares," said Gregg Wolper, senior fund analyst for Morningstar in Chicago. Some firms will charge an exit fee for traders who sell shares before 60 days while others reserve the right to ban investors.
Fair value also isn't necessarily fair. Because there are no rules on how fair value pricing should be implemented; funds have a remarkable amount of leeway in how they adjust for the expected change in value overnight of their holdings in foreign equities. This can lead to significant discrepancies in pricing between funds and can impact investors' returns.
"The Securities and Exchange Commission only requires mutual fund boards to fair value their securities," said Steve Keen, counsel with the Pittsburgh law firm of Reed Smith. "There is no regulatory requirement on how it should be done, leaving some room for interpretation."
Interactive Data says it relies on a process called multifactor regression to price a non-U.S. security. By contrast, ITG uses six pricing models, each representing a different factor such as the S&P 500 futures, exchange traded funds and sectors.
Instead of combining many factors to adjust the fair value, the firm selects one factor based on historical performance.
"Our research showed that there was no advantage to using a multifactor approach and the single factor approach was much simpler to interpret and more transparent," said Robert Harrington, product manager for ITG's fair value service. "In addition, the multifactor regression approach has an important drawback. Since the factors utilized are highly correlated, quite often regression coefficients are not stable and all of the factors combined together in a multi-factor regression introduce noise rather than useful information."
The SEC's guidance in 1999 and 2001 only focused on funds' obligations to monitor events and determine when market quotes are not "readily available" by the time a fund calculates the net value of its assets.
The SEC ruled that funds must take "reasonable steps" to ensure that the price of fund portfolio securities reflect their value. The prices, said the SEC, must be "fair" to purchasing, redeeming and existing shareholders, regardless of whether they are long-term or short-term.
At the core of the regulator's guidelines is what constitutes a "significant" event.
"Some funds interpret the significant event to be any market movement following the local market's closing time whether large or small. Others may determine there has to be a minimum price movement in the U.S. market," said Haddad.
Interactive Data's survey found that, of firms using triggers, 24 percent required a certain benchmark such as the S&P 500 index moves either up or down by 50 basis points. The remaining funds relied on a trigger of 25 basis points, 75 basis points, 100 basis points or more complex procedures such as multiple benchmarks.
Who decides what the trigger is? The fund board, by back-testing the effectiveness of different triggers. Back-testing measures just how close the price calculated by the mutual fund or its evaluations provider, such as Interactive Data or ITG, is to the actual price that occurs at the start of the foreign market's exchange.
However, there are no definitive answers on whether it is best to measuring fair value in international securities daily or only when certain market conditions are met. "It's a tradeoff," Harrington said. "The mutual fund company doing fair value on a daily basis is confident it is protected from arbitrage every day but performance on days with smaller market moves tends not to be as strong."
Alternatively, he says, the firm using only a specific trigger is confident that performance on those days improves. But days when the trigger is not pulled leaves values on those days at risk of being off. "When it comes down to it, it's just as much about art than science," Harrington said.