FAIR VALUATION AND THE POTENTIAL

CONSEQUENCES OF MISPRICING-MUTUAL FUNDS____________

Just how important correct valuations are can be illustrated by the particular examples of mutual funds that invest in global markets. For example, let's think of a U.S.-domiciled mutual fund that invests in Asian securities: The mutual fund is required to calculate a daily NAV, which would typically be done at 4:00 P.M. Eastern time (ET), when the New York Stock Exchange closes. At this time, the readily available price quotes for Asian stocks are the respective closing prices in the respective local exchanges. However, let's note that these local closing prices at this point are anywhere between 11 to 15 hours old ("stale"). Do they still reflect fair value, 11 to 15 hours later at 4:00 P.M. ET? Significant market moves in the United States are known to affect prices in other time zones.

Why does it matter? The problem arises when there is additional information available, disseminated after the local markets close, that-had the local markets been open-would have affected the local share prices. Analyzing this type of subsequent information, an investor has the opportunity to draw the conclusion that the price as of the local close would have changed in a certain direction had the local markets still been open. So, equipped with this conclusion, our investor now has an arbitrage opportunity to buy or sell a mutual fund, priced based on local closing prices, at a discount or premium respectively versus the estimated fair valuation, based on the subsequent information. Such activity implicitly leads to a transfer of value from the fund (and therefore all existing shareholders) to our investor; let's call this the "dilution effect." Academic studies have shown that arbitrage trading in internationally invested funds can earn annualized excess returns of 40 to 70 percent. Evidence from a sample of funds suggests that long-term shareholders may be losing up to 2 percent of assets per year to dilution effects (Zitzewitz 2002).

Example: October 28, 199710

Asian markets were down, following a 9% prior day drop in the S&P 500, but after Asian markets closed, the U.S. market rallied by 10% from its morning lows. Most U.S. based Asian funds used local closes, allowing arbitrageurs to earn one-day returns of 8-10%. [See Table 18.1.]

On Day 1, the Asian market closes (at 3:00 AM. Eastern time) significantly lower causing the value of the securities held in the fund to decrease by 10%. During Day 1, U.S. trading in other instruments indicates. . . the prevailing increase in value of approximately 10%, which strongly suggests that stock prices in the Asian market when it opens will increase to a similar level as before the previous day's decrease. Knowing this, investors buy $10 million worth of shares to try to take advantage of the arbitrage opportunity. At the end of Day 1, using the share prices at the close of the Asian market, [the fund] calculates its NAV at $9 per share. This is the price at which investors buy shares of the fund.

10Letter to Craig S. Tyle, general counsel, Investment Company Institute, from Douglas Scheidt, associate director and chief counsel, Division of Investment, U.S. Securities and Exchange Commission, dated April 30, 2001, Exhibit 1.