In 2009 more than 87 million Americans were invested in mutual funds, but it is unlikely that more than a handful outside of the industry had any idea how these funds work. Robert Pozen and Theresa Hamacher set out to educate the investor in The Fund Industry: How Your Money Is Managed (Wiley, 2011). The education is thorough, clear and enjoyable. I highly recommend it.
The 500+-page book is divided into five sections: an investor’s guide to mutual funds, mutual fund portfolio management, selling investment funds, operations and finance, and the internationalization of mutual funds. The book is chock full of information that I readily admit I was completely ignorant of. I debated what to share in this post and decided on the daily net asset value (NAV) calculation. This may seem an obscure topic, but after all it determines what an investor’s mutual fund holdings are worth on any given day. And it’s nowhere near as straightforward as I assumed.
Each business day the fund’s accountant has until 5:50 p.m. ET to compute the fund’s NAV (referred to in the trade as striking the NAV) and transmit it to NASDAQ for dissemination the next day. Striking the NAV is the culmination of accounting activity that takes place over the course of the day. The fund accountant starts by projecting cash availability, then records portfolio trade activity and capital stock activity, processes corporate actions, records expense accruals (both 12b-1 and non-12b-1), and calculates and records distribution amounts. Once the NYSE closes at 4, each security in the fund’s portfolio (bonds as well as stocks) must be priced.
Sounds relatively simple, doesn’t it? For U.S. stocks, it usually is: a stock’s value is the price of the last transaction reported on the consolidated tape. But other securities have different methods of valuation. For instance, most bonds are valued using matrix pricing; thinly-traded investments are sometimes priced at the average of the bid and the offer.
Non-U.S. securities present a special problem. Mutual funds use forward pricing; that is, if an investor places an order at 4:01 p.m. or later, the order will be priced at the next business day’s NAV. But “valuations for foreign securities are established when their local markets close—and because of time zones they may close long before the U.S. market even opens. Yet investors in funds investing in those countries can continue to make purchases and sales of fund shares until 4 p.m. Eastern Time…. In effect, funds that own a lot of foreign securities use backward pricing—giving investors the opportunity to game the system by watching the performance of the U.S. market.” (p. 372)
Fund boards of directors may opt to close this time zone gap by using fair valuation, using U.S. futures contracts to adjust the price of its holdings. Take a U.S. fund heavily invested in Japanese stocks. A pricing committee may compare the 4 p.m. price of the U.S. Nikkei 225 futures contract to the value of the Nikkei at the close of the Tokyo Stock Exchange and adjust accordingly.
Fair valuation can be applied at other times as well. For example, a fund’s policies might require fair valuation if trading is suspended in a security—or an entire market—or if there has been a natural disaster overseas that occurred after the close of the local market but before the close of the New York Stock Exchange.(p. 374)
I think most people will find The Fund Industry one of the most informative books they’ve read in quite a while. And that’s a shame. It shows that mutual fund investors know mighty little about where they’ve put their hard-earned money.