What Is Fair Value Pricing for Mutual Funds?

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Mutual Fund Education

What Is Fair Value Pricing for Mutual Funds?

David Dierking May 09, 2017

Most investors understand that a mutual fund’s net asset value (NAV) reflects the total value of the portfolio based on the most recent share prices available. But what if some of those share prices are stale and don’t necessarily reflect the current value of the security?
That’s where fair value pricing may be used. In this article, we’ll examine how fair value pricing work as well as some of its benefits and drawbacks.

What Is Fair Value Pricing?

Fair value pricing is the process by which fund managers estimate the value of a security within a fund where a current price isn’t readily available. The concept was introduced by the Investment Company Act of 1940 and established that fund managers may act in good faith to determine the fair market value of a security if they feel it more accurately reflects its current value.

This most frequently occurs with foreign stocks where the markets for these securities are often closed while the U.S. markets are open. For example, a healthcare fund owns a stock that trades on the Asian markets. After that market is closed, a regulation passes that will lower drug prices across the industry and drug company stocks plunge. Even though the stock of this Asian drug company hasn’t traded since the news, it’s reasonable to believe that the stock will drop significantly as well. In this situation, the fund’s managers may use fair value pricing to lower the price of that stock in the fund’s NAV calculation in order to reflect the current environment.

Using the above scenario as an example, the fund may own shares of XYZ Company, whose last traded price was $100 per share. If domestically traded healthcare stocks dropped roughly 5% on the news, the fund’s managers may use fair value pricing to assign a $95 share price to XYZ. This practice gives the ETF a truer NAV calculation in the near-term until more recent pricing data can be obtained.

To familiarize yourself with how NAV is calculated for mutual funds, click here.

Situations Where Fair Value Pricing Is Needed

While the example above of international markets trading at different hours is perhaps the most common instance where fair value pricing is used, it’s far from the only one. Here are a few more instances where a fair value pricing may be implemented.
  • Significant world and market events – Events occurring all around the world can potentially interrupt the normal trading environment. The 9/11 attacks on the World Trade Center are a good example of this. The stock market remained closed until September 17th and it was assumed that the indices would drop significantly when trading resumed. In a situation such as this, fund managers could use fair value pricing to more accurately price the portfolio until trading resumed.
  • Hard-to-value securities – Some securities trade very infrequently. This can make it difficult to obtain current pricing when no recent trade data is available. Fair value pricing can establish a more reasonable estimate of the current value.
  • Investments in private companies – Companies that don’t trade publicly present challenges in establishing fair value. While establishing an accurate price may be difficult, fair value pricing can help put a sensible estimate on the investment.
  • Technical glitches on the exchanges – Technical issues sometimes interrupt trading in single securities or an entire exchange. On August 22, 2013, the Nasdaq was shut down for around three hours due to server connectivity issues. The issue was resolved prior to the end of the trading day allowing for real-time data to be established for most securities. Had the delay lasted through the market close, fund managers would have used fair value price for much of the portfolio.

In case if you are wondering whether mutual funds are right for you at all, you should read about why mutual funds, in general, should be a part of your portfolio.

Drawbacks of Fair Value Pricing

The obvious benefit of fair value pricing is that it gives fund managers the ability to, in most cases, more accurately price the fund. There are several potential issues, however, in using price estimates within a portfolio.
  • First, the fair value price is just an estimate. It could end up being too high or too low resulting in a mispriced fund. Arbitrageurs, in turn, could step in an attempt to profit off of the mispricing.
  • Second, fair value pricing is subjective. Every fund manager has his or her own criteria and modeling for establishing a price. As a result, when fair value pricing approach is triggered, the same security may end up with different prices.
  • Third, the process could also be open to fraud if a security is purposely mispriced.

The Latest Trends Regarding Fair Value Pricing

The focus on fair value pricing policy continues to center on robust pricing procedures and active oversight of pricing processes. According to Deloitte’s latest Fair Valuation Pricing Survey, 63% of participants revised their procedures in the past year implementing changes such as adding more pricing sources to its model and increasing the input of a separate pricing committee. Governance was also an emphasis as companies added non-interested members to pricing committees and engaged third-party consultants to handle fair value pricing policies.

The Bottom Line

Fair value pricing is an important part of accurately pricing a fund’s shares and helps fund managers with the ability to adjust a fund’s price under unforseen circumstances. Managers are getting more serious about doing it the right way as increased governance surrounding fair value pricing procedures is a further step in the right direction.

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