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News February 20, 2006 Issue

Funds Base NAVs on Day-Old Holdings, Leading to Inaccurcies, Study Finds

A new academic study is casting doubts on the accuracy of mutual funds’ NAV calculations.

In a 50-page draft paper released January 30, Peter Tufano and Ryan Taliaferro of Harvard Business School, and Michael Quinn, an economist at Analysis Group, discussed the "common and insidious" practice of mutual funds applying current prices to day-old portfolio holdings information to determine the fund’s NAV.

When "calculating today’s NAV," explained the authors, "fund pricing services use today’s prices applied to yesterday’s portfolio," or, put another way, "live prices and stale quantities." As a result, any securities bought or sold the date the NAV is calculated are not reflected in the NAV, as if the fund did not make any trades during the day. This accounting approach, said the authors, is "used by virtually all U.S. mutual funds."

The study found that this "mispricing" can cause NAV distortions, particularly when a fund invests in securities that are highly volatile, when a fund trades early in the day, and when the fund makes "many and sizeable" trades. The authors found that distortions average "a penny or two for NAV distortions, or a few basis points for return distortions." Using model data, the study predicted a 4.7 percent likelihood of a fund having a penny NAV distortion. Using actual data from 26 equity funds, however, the study found a 8.9 percent likelihood of a penny NAV distortion. The study estimated distortions of about $104 million annually.

The study’s authors noted that the practice of T+1 fund accounting has so far avoided public notice. One of the goals of the paper, they said, "was to alert otherwise-informed mutual fund experts about the use of stale portfolio information in the construction of net asset values." They found that the practice was well-known to fund accountants.

The study’s authors did not accuse the funds of any misdoing. Indeed, they noted that T+1 accounting is "sanctioned" by ICA Rule 2a-4. "Any distortions in NAVs or returns we calculate are the result of the funds fully complying with Rule 2a-4, not failing to comply with all stated rules and regulations," they said.

However, the authors suggested that once the practice comes to light, mutual fund investors might "vote with their feet" and move over to other investment vehicles. "The recognition that NAVs and returns are incorrect — and that the industry is unconcerned with correcting the distortions — can only decrease public confidence in the mutual fund industry."

The study examines three possible policy responses: doing nothing, heightening disclosure, or requiring funds to apply current prices to current holdings information. "Initial reactions to this paper from consumer advocates and industry executives tend to focus exclusively on a small set of arguments," said the authors. "Our goal is to call these distortions to attention, and frame the debate so that regulators, fund trustees, fund auditors, consumer advocates and investment management professionals can carefully examine whether shareholders’ interests are best served by a rule that was conceived and justified decades ago."