In this article Tony Evangelista discusses some of the ways US investment funds and the SEC have addressed fund arbitrage.
The increasing interest in fund arbitrage and its potential dilutive impact on existing shareholders heightens the need for investment funds everywhere to design and implement equitable and consistently applied processes for the fair valuation of fund assets.
The ability to time an investment to statistically guarantee a net positive
return (arbitrage) is big business to sophisticated investors and typically
results in diminished returns to long term shareholders.
The US Securities and Exchange Commission (SEC) has issued interpretative letters focusing on the use of fair value pricing procedures when market quotations are not readily available, especially in the context of foreign securities, as a means to thwart market timers.
Their letter of April 30, 2001 focused on situations where a fund's pricing
policy is to value a security based on last trade activity that may be 12 to
15 hours old (for example a US mutual fund holding securities principally traded on Asian exchanges), and an intervening event (from natural disasters to significant government actions to issuer-specific news) makes the closing price of that security (and the portfolio net asset value which includes it) unreflective
of current market value.
A recent academic study shows that with increased volatility in international markets, and the tendency for foreign markets to open following the US directionally, fund arbitrage could be generating a potential USD 5 billion in profits a year to arbitrageurs.
In 1998-2001, short term investors profiting from discrepancies between stale last trade prices and the ultimate value of impacted securities could have
earned a potential annual return of 35-70%, double what they could have made in 1992 to 1996 (see Footnote 1).
The use of fair valuation is a proven tool to minimise abusive arbitrage opportunities. While there are certain external service providers that provide fair valuation services for a fee (see Footnote 2), many funds have chosen to employ fair value procedures themselves, using some or all of the practices listed below (A).
While fair valuation processes have been successful in mitigating the impact
and potential dilution of arbitrage, some funds have enlisted other
strategies to block or deter arbitrageurs listed below (B).
A) Fair value procedure considerations
• Use of valuation committees for valuation and pricing issues;
• Enhanced involvement in valuation of securities that are traditionally or
inherently difficult to value;
• Review of pricing service provider methodologies; use of more than one
pricing service to provide a check for reasonableness;
• Automated checking routines to identify day-to-day price changes in
individual securities over a threshold amount (e.g., 3%, 5%);
• Enhanced controls related to price overrides, such as supervisory approval
and documentation and timely review of all overrides by someone
independent of the pricing process;
• Monitoring of "stale priced" securities (i.e., those securities whose value has
not changed over a specified period of time, such as 5 days); and
B) Arbitrage deterrence strategies by investment managers
• Imposition of short-term trading fees - a fee (e.g., 0.75%) deducted from
the redemption proceeds where the shares are sold within 30 days of
purchase. Short-trading fees are paid typically to the fund and are designed
to offset the incremental costs and commissions caused by short-term
• Outright rejection of purchase orders, including exchanges - typically
rejected based on traders that have a pattern of short-term or excessive
trading or whose trading has been or may be disruptive to the fund's
• Enhanced monitoring of traders to determine patterns of trading and any
history of past abuses or disruptive trading practices; and
• Delayed exchanges - the right to hold or delay an exchange in an effort to
randomise or neutralise the probability of a guaranteed return.
With increased market volatility and the enhanced tools that market timers have, the fund arbitrage issues have become more complex, but there is much that
an investment manager can and should do to protect their funds and their long term shareholders.
Tony Evangelista, PricewaterhouseCoopers, New York
1 Eric Zitzewitz, Stanford Graduate School of Business, October 2002; Research Paper No. 1749 Who Cares About Shareholders?
Arbitrage-Proofing Mutual Funds; a similar study by FT Interactive Data, found that in July 2002, alone, this strategy would have earned 12% or 146% annualised.
2 The primary ones being FT Interactive Data and Investment Technology Group, Inc. (ITG)
copyright hedgeweek 2003