Extending the practice of fair-value pricing to indexes is being proposed to create better benchmarks, but some index providers aren't buying that idea.
Fair-value pricing is common practice among mutual funds to thwart those who exploit stale stock prices, but it isn't employed by index providers, which produce the benchmarks mutual funds track. But that is an oversight that should be corrected, according to
The Vanguard Group Inc.
"We're constantly having a dialog with various index providers that want to know what we're interested in, and we're interested in an index that incorporates fair-value pricing," said George U. "Gus" Sauter, chief investment officer of the Malvern, Pa., company.
Fair-value pricing is a mathematical process used to estimate a price for securities when the actual price is difficult to determine — due to time zone changes or a triggering event, for example.
It is particularly popular with funds that invest in foreign securities where the closing price on a foreign stock exchange — Hong Kong's, for instance — may be as much as 16 hours old and doesn't reflect events that have transpired since the market closed.
As long as the index providers fail to adjust their indexes — especially those that contain foreign stocks — their indexes won't be truly accurate tools for comparing mutual funds that use fair-value pricing with their securities, Mr. Sauter said.
Vanguard should be applauded for pushing the issue, said Rick Miller, a financial planner with Sensible Financial Planning and Management LLC in Cambridge, Mass.
Indexes' non-reliance on fair-value pricing can be a problem when evaluating all mutual funds, but especially index funds that many advisers select based on how well they track an index, he said.
"If you measure success by tracking error, then fair-value-pricing a portfolio could cause you to have significant tracking error day to day or even month to month," said Mr. Miller, a proponent of index investing.
Of course, short-term deviations in performance that result from fair-value pricing should have little effect on how well a fund tracks its benchmark over the long term, he added.
But that doesn't mean that index providers should ignore the issue, Mr. Miller said.
One of the biggest index providers, however, sees it differently.
While the desire of fund companies and others that indexes make fair-value adjustments is understandable, index providers do not feel that such adjustments are necessary — at least with regard to foreign securities, said Srikant Dash, head of global research and design at Standard & Poor's Index Services, a unit of S&P in New York.
"It's more of an educational issue than a technical issue," he said.
Investors should be aware of stale prices, but for index providers to try to adjust those prices to reflect events that might affect price would be a mistake, Mr. Dash said.
That's because any price that's determined via fair-value pricing will be an "artificial" price, and indexes are intended to reflect "actual" prices, he said. That doesn't mean index providers will never agree to fair-value pricing, Mr. Dash said.
While stale prices of foreign securities are an educational issue, stale prices that result from factors such as illiquidity are "systematic" issues for which indexes may be able to adjust, he said.
For example, Standard & Poor's uses a pricing service to help determine the fair value of municipal bonds within its muni indexes, Mr. Dash said. It's necessary because the muni market is so illiquid, he added. Standard & Poor's, however, doesn't adjust other indexes for fair value, Mr. Dash said.
At least it doesn't yet.
"We have had some discussion with different product issuers — open-ended discussion — where there has been talk of illiquid markets where securities could be fair-value-priced," Mr. Dash said.
He cautioned, however, not to read too much into that.
Standard & Poor's has no plans to bring out other fair-value-adjusted indexes, Mr. Dash said, and neither does it appear that other index providers intend to do so. "We haven't seen that much client demand for [such indexes]," said a spokeswoman for Dow Jones Indexes, a division of Dow Jones & Co. Inc. of New York.
Other index providers did not return calls for comment.
At least one financial adviser agrees with those who don't see the need to fair-value-adjust indexes.
"I'm not sure what the beef is," said Jeffrey Broadhurst, president of Broadhurst Financial Advisors Inc. in Lansdale, Pa.
It's shortsighted not to fair-value-adjust indexes, said Ian Domowitz, a managing director with ITG Inc. of New York.
"We have a situation where asset managers are being benchmarked against a particular index, and even if they do a perfect job, they are penalized if they fair-value-price," he said.
It would be fairly easy for an index provider such as ITG to team with a third-party provider to fair-value-adjust indexes, Mr. Domowitz said.
The reason they don't is that index providers simply don't want to put in the effort, he said.
Nine of 10 asset managers use third-party fair-value-pricing vendors to value foreign equities, according to a study on fair-value practices released in August by Deloitte & Touche USA LLP of New York.
Times, however, are changing, Mr. Domowitz said.
Fair-value pricing is becoming more accepted. For example, in 2006, 74% of survey respondents used a firm such as ITG to determine the fair value of foreign securities, according to the Deloitte study. The percentage of respondents that used third-party vendors was 21% in 2004.
"I believe that it is certainly more possible today that index providers will fair-value-adjust their indexes simply because the movement toward fair valuation has grown over time," Mr. Domowitz said.
Having a firm such as Vanguard as a champion of the cause certainly helps, he said.
David Hoffman can be reached at [email protected].
