Predictable pricing errors and fair value pricing of US‐based international mutual funds
| Pages | 132-150 |
| DOI | https://doi.org/10.1108/13581980410810759 |
| Published date | 01 June 2004 |
| Date | 01 June 2004 |
| Author | Timothy E. Jares,Angeline M. Lavin |
Predictable pricing errors and fair
value pricing of US-based international
mutual funds
Timothy E. Jares and Angeline M. Lavin*
Received (in revised form): 24th February, 2004
*School of Business, Department of Finance, University of South Dakota, 414 E. Clark St., Vermillion
SD 57069, USA; tel: +1 605 677 5566; fax: +1 605 677 5058; e-mail: alavin@usd.edu
Tim Jares is an assistant professor of
finance and Assistant Dean in the Monfort
College of Business at the University of
Northern Colorado. He earned his PhD
from the University of Nebraska-Lincoln in
1998. Tim teaches investments and corpo-
rate finance. His current research is in the
areas of fair value mutual fund pricing,
exchange-traded mutual funds, business
valuation techniques and experimental
financial markets. Tim has also served as
an industry consultant in information tech-
nology and business valuation.
Angeline Lavin is an associate professor of
finance at the University of South Dakota in
Vermillion. She obtained her PhD from the
University of Nebraska-Lincoln in 1997 and
earned the Chartered Financial Analyst
(CFA) designation in 2000. She teaches
many investments courses including princi-
ples of investing, security analysis, portfolio
management, derivatives and financial
administration. Her current research
focuses on fair value mutual fund pricing,
exchange-traded mutual funds, the impact
of tax policy on taxpayer behaviour and
earnings restatements.
ABSTRACT
KEYWORDS: mutual funds, fair value pri-
cing, exchange-traded funds
Fair value pricing is a critical issue for mutual
funds with international market exposure
because trading in the underlying foreign securi-
ties is not synchronous with US market trading.
Using a sample of Japanese open-end mutual
funds that trade in the USA, this paper
explores the potential for exploitation of
common mutual fund pricing practices and iden-
tifies much larger pricing errors than previously
reported. A simple, objective solution to the fair
value pricing quandary is proposed. The solu-
tion, based on foreign exchange-traded funds
and the S&P 500, provides a timely, objective
pricing alternative that is less exploitable than
current mutual fund pricing practices.
The mutual fund industry has flourished
thanks to the benefits it provides to indivi-
dual investors. Mutual funds enable small
investors to diversify their investment
holdings easily and start with small invest-
ments at a low cost. Mutual funds also pro-
vide the benefit of liquidity. By law, all
open-end mutual funds (hereafter referred
to as mutual funds), which do not have a
fixed number of shares, must stand ready
to redeem shares on shareholder demand.
In contrast, closed-end mutual funds,
which have a fixed number of shares out-
standing, do not redeem outstanding
shares. To satisfy redemption requirements
and accommodate new investors, mutual
Page 132
Journal of Financial Regulation and ComplianceVolume 12Number 2
Journal of Financial Regulation
and Compliance, Vol. 12, No. 2,
2004, pp. 132–150
#Henry Stewart Publications,
1358–1988
funds must value their portfolios and deter-
mine share prices at least daily. To be fair
to incoming investors and to prevent dilu-
tion of current investor holdings, fund
prices must accurately reflect the portfolio
value at the time those net asset values
(NAVs) are calculated.
Accurate pricing is particularly critical to
existing shareholders because they are
powerless to prevent new shareholders
from diluting their interests. For example,
if the NAV is predictable and if it is set
below the true value of a share in the fund,
incoming shareholders can and will benefit
at the expense of existing shareholders.
Objective pricing practices are also key to
aligning the interests of fund management
and fund shareholders.
1
Open-end mutual fund pricing complex-
ities emanate from a variety of sources. For
example, some funds hold complex deriva-
tives, privately placed debt and emerging
market securities. The listed and unlisted,
traded and non-traded securities from
around the world that some US-based
mutual funds hold are another source of
complexity. The lack of clear, objective
pricing data for this broad array of securi-
ties, coupled with timely pricing require-
ments, has led to complicated and
subjective pricing practices.
Motivated by controversial ‘fair value’
pricing decisions by some mutual fund
companies as well as recent and proposed
innovations in the industry, this paper
explores the potential for exploitation of
common mutual fund pricing practices.
The authors conjecture that the potential
for exploitation appears to be greatest for
those markets with trading days that pre-
cede the US trading day by the greatest
amount. Therefore, the analysis focuses on
the Pacific Rim. Due to the authors’
unique approach, much larger pricing
errors than have been reported by other
authors are identified.
An alternative, objective solution to the
fair value pricing quandary faced by the
mutual fund industry and its regulators is
also proposed. The solution, based on for-
eign exchange-traded mutual funds (ETFs),
provides a timely pricing alternative that is
far less exploitable than current interna-
tional mutual fund pricing practices and is
potentially less exploitable and more
timely than policy recommendations sug-
gested in previous research. The purpose of
the proposed adjustment is to include the
predictable portion of the next day NAV
in today’s NAV.
To determine objectively the predictable
portion of the NAV, regression analysis is
used to extract relevant information from
current day movements in iShares Japan
ETF and S&P 500 returns. Previous
research has attempted to accomplish this
goal using adjustments based only on the
S&P 500. ETF-based adjustments, how-
ever, are particularly pertinent in the case
of single-country funds, such as Japan
funds, because they enable adjustments
based on information specific to the home
country. It is also possible to incorporate
other iShares ETF funds for more geogra-
phically diversified international mutual
funds. The adjusted NAV is determined by
simply adding the predicable portion of the
NAV to the traditionally calculated NAV.
Thus, this paper expands on previous
research by using both the iShares Japan
ETF and the S&P 500 returns as instru-
ments in the adjustment process in order to
incorporate value-relevant information in
the NAV of the mutual fund and reduce
the predictability of short-term returns.
Fair value pricing of mutual fund shares
is a timely topic of great interest not only
to mutual fund firms and professional
investment managers, but also to individual
investors who make trading decisions for
their personal portfolios and regulatory
entities such as the Securities and Exchange
Commission (SEC). The importance of fair
value pricing has been highlighted by the
Page 133
Jares and Lavin
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