Consideration of Fair Value and International Securities

Posted by admin on Apr 12, 2013 6:23:44 PM

Long has the fair valuation of portfolio securities of investment companies been under scrutiny by regulators and auditors. Under the risk-based approach to auditing, fair valuation of investments remains one of the pillars for which effective auditing procedures are designed. In a 2001 letter to the Investment Company Institute, the Securities and Exchange Commission made the following comments in regard to fair valuation of portfolio securities:

The 1940 Act requires funds to calculate their net asset values ("NAVs") by using the market value of their portfolio securities when market quotations for those securities are "readily available." When market quotations for a portfolio security are not readily available, a fund must calculate its NAV by using the fair value of that security, as determined in good faith by the fund's board. Funds generally calculate their NAVs by using the closing prices of portfolio securities on the exchange or market on which the securities principally trade. Many foreign markets, however, operate at times that do not coincide with those of the major U.S. markets. As a result, the closing prices of securities that principally trade on foreign exchanges or markets ("foreign securities") may be as much as 12-15 hours old by the time of the funds' NAV calculation, and may not reflect the current market values of those securities at that time.

In consideration of the global market for which many of the U.S. domiciled funds operate, the letter to the ICI went on to describe significant events, whether domestic or international, that may impact the fund’s calculation of a fair market value:

In particular, the closing prices of foreign securities may not reflect their market values at a fund's NAV calculation if an event that will affect the value of those securities ("significant event") has occurred since the closing prices were established on the foreign exchange or market, but before the fund's NAV calculation.

Funds may dilute the value of their shareholders' interests if they calculate their NAVs using closing prices that were established before a significant event has occurred. The risk of dilution increases when significant events occur because such events attract investors who are drawn to the possibility of arbitrage opportunities. In such situations, short-term investors may attempt to exploit the discrepancies between market prices that are no longer current, and the values of a fund's portfolio securities. Fair value pricing can protect long-term fund investors from short-term investors who seek to take advantage of funds as a result of significant events occurring after a foreign exchange or market closes, but before the funds' NAV calculation.

With regard to a foreign security, a fund must evaluate whether a significant event (i.e., an event that will affect the value of a portfolio security) has occurred after the foreign exchange or market has closed, but before the fund's NAV calculation. If the fund determines that a significant event has occurred since the closing of the foreign exchange or market, but before the fund's NAV calculation, then the closing price for that security would not be considered a "readily available" market quotation, and the fund must value the security pursuant to a fair value pricing methodology.

In response to the possibility of arbitrage opportunities, several funds have implemented a safeguard against short-term trading, instituting a redemption fee charged against investors liquidating their short-term position in the fund. While this tactic has reduced the amount of market timing of an international fund, FASB topic 820-10 of the Codification (old FASB Statement No. 157) does not preclude fund managers from determining fair value or, "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” When determining fair value of portfolio investments, a fund manager and its Board must keep in mind the governing instructions of topic 820-10. Fair valuation of investments is to be assessed using mindful judgment of the prevailing circumstances, while keeping in mind the approved valuation policies established by the Board.

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