Net Asset Value Calculation



From PLI’s Course Handbook

ABCs of Mutual Funds 2009

#18809

2

Pricing and valuation of mutual fund shares

Allen M. Goldstein

PricewaterhouseCoopers LLP

Prepared March 26, 2009

The sections below, “Net Asset Value Calculation” and “Valuation” are excerpted from Chapter 30 “Mutual Fund Accounting and Financial Reporting” of the Practising Law Institute Publication “Mutual Fund Regulation”; this chapter was authored by Martin Jennings and Richard Grueter, Partners and Allen Goldstein, Managing Director at PricewaterhouseCoopers LLP.

The ABCs of Mutual Funds 2009

Pricing and Valuation of Mutual Fund Shares

June 10, 2009 ( Prepared March 26, 2009)

Allen M. Goldstein, PricewaterhouseCoopers LLP

The sections below "Net Asset Value Calculation" and "Valuation" are exerpted from Chapter 30 " Mutual Fund Accounting and Financial Reporting" of the Practicing Law Institute Publication " Mutual Fund Regulation"; this chapter was authored by Martin Jennings and Richard Grueter, Partners and Allen Goldstein, Managing Director at PricewaterhouseCoopers LLP.

Net Asset Value Calculation

An open-end investment company stands ready to redeem its capital shares as described in its prospectus and in accordance with Rule 2a-4 (and, for money market funds, Rule 2a-7), normally on business days when the New York Stock Exchange is open.

Rule 2a-4 defines “current net asset value” for use in computing the current price of a redeemable security as follows:

|Net Asset Value |= |(market value in dollars of fund’s assets minus fund’s | |

|(NAV) | |liabilities) | |

| | |number of investor shares outstanding | |

The Rule specifies that current NAV be an amount that reflects the following items, with estimates used where necessary or appropriate.

| |Valuation/Timing Guidance |Other Comments |

|1. Portfolio securities |Current market value. |The SEC staff has provided |

|market quotations are | |guidance to the industry that |

|readily available | |market quotations that are |

| | |readily available should also |

| | |be reliable, and thus should |

| | |consider significant events |

| | |that may affect the reliability|

| | |of the market quotations.1 |

|2. Portfolio securities |Fair value as determined in | |

|market quotations are NOT |good faith by the board of | |

|readily available |directors of the registered | |

| |investment company. | |

|3. Changes in holdings of |Must be reflected no later than| |

|portfolio securities |in the first calculation of the| |

| |first business day following | |

| |the trade date. | |

|4. Changes in the number of |Must be reflected no later than|Includes changes resulting from|

|outstanding shares of the |in the first calculation on the|distributions, redemptions or |

|registered company |first business day following |repurchases. |

| |such change. | |

|5. Expenses |Must be included to the date of|Expenses include any investment|

| |calculation. |advisory fees. |

|6. Dividends receivable |Included to the date of | |

| |calculation either at | |

| |ex-dividend dates or record | |

| |dates, as appropriate. | |

|7. Interest income and other|Must be included to the date of| |

|income |calculation. | |

Expenses, dividends and interest income need not be reflected if cumulatively, when netted, they do not amount to as much as one cent per outstanding share. This standard has given rise to the so-called “penny per share rule,” which is often applied as a materiality standard for the correction of accounting errors of any kind (not just income or expense matters) that may have led to fund shares being issued or redeemed at incorrect prices.

Money market funds abide by additional standards beyond the general standards of Rule 2a-4. Rule 2a-7 permits the fund to use either the amortized cost method of valuing securities (instead of market values) or a “penny rounding” method of determining net asset value. Either is intended to maintain a stable (usually $1) net asset value per share for purposes of share issuances and redemptions, so long as certain conditions are met. Those conditions relate to the composition and management of the portfolio itself, including minimum quality requirements, maximum maturities (both for individual securities and on a portfolio-weighted basis) and portfolio diversification requirements.

Directors/trustees of money market funds need to conclude that the fund’s procedures are reasonably designed to consistently produce a value which approximates the market-based net asset value per share of the fund. These procedures must produce values normally within a precision level of one half of one percentage point and confirm, through periodic testing against market values, adherence to this level of precision (a practice commonly called “shadow pricing”). This determination may be more difficult when short term interest rates are volatile or when an unexpected credit event affects a portfolio security.

The fund accountant effectively serves as a control center for calculating the NAV. In order to calculate the daily NAV per share, the fund accountant normally assembles the following information each business day:

• the portfolio managers’/traders’ listing of portfolio transactions;

• custodian listings of cash transactions (income collected, portfolio transactions settled) and other income earned and receivable;

• transfer agent summaries of shareholder transactions and resulting cash movements;

• securities valuations provided by the fund’s pricing service at the predetermined time;

• accounting system calculation of daily interest accruals or, through feeds from information services, identification of which equity securities have gone ex-dividend and calculation of the related dividend income; and

• expense accruals provided by the fund accountant or administrator.

The fund accountant must also determine that all of the information collected from the other service providers is consistent before the NAV is calculated (for example, does the transfer agent’s reports of cash movements agree to the custodian’s reported amounts?) and then combines all of it to calculate NAV.

Most funds impose an internal deadline to complete NAV calculations by the time required to submit them for publication in newspapers and other media: typically 6 p.m. Eastern Time. That NAV is then used to process all capital share transactions overnight. The process is repeated the next business day.

Valuation

A mutual fund’s most significant assets are normally its investment securities. To fairly treat all investors who purchase and redeem capital shares, the challenge becomes how to appropriately value each portfolio security and accrue income properly each business day.

As funds increasingly invest in global securities and complex instruments such as derivatives and swaps, accountants are challenged to understand these securities and their income and valuation attributes so that the daily accounting process can be properly performed. Questions are being asked concerning how funds should determine the values of credit derivatives, swaps and similar emerging financial instruments.

The industry’s accountants recognize the gravity of this responsibility and normally value securities by using closing prices on the principal exchanges where the securities trade. However, recent market timing activities and academic research suggest that, if the last reported trade in a security occurs hours before the fund values its portfolio and calculates its NAV, that last price (which may be reported as the closing price for the day by the exchange) may not represent market or fair value at the time the NAV is calculated. (2)

This is a significant matter, particularly for foreign securities where exchanges close hours before fund shares are priced. SEC staff comments on this have captured the attention of fund accountants, directors and management; the SEC has suggested that there are more opportunities to use “fair value” pricing (that is, values updated for more current market information) when direct market values are not readily available or are not reliable.(3) Under Rule 38a-1 of the 1940 Act, funds must “adopt policies and procedures to monitor for circumstances that may necessitate the use of fair value prices; and establish criteria for determining when market quotations are no longer reliable for a particular portfolio security.”

Pricing services may provide daily factors for foreign and thinly traded securities, updated through the use of statistical correlation techniques, which can be used to adjust local exchange closing prices for subsequent U.S. market fluctuations. With the advent of these services, fund directors have begun to inquire about their responsibilities to understand how these services control their operations, what “triggers” may be used to determine when foreign securities’ closing prices are no longer reliable or indicative of value at the time a fund is priced, and how to monitor the continuing adequacy of “fair value” prices, once adopted, on an ongoing basis.

SEC staff guidance indicates that fund directors should exercise independent, objective oversight and judgment with respect to valuation and pricing procedures. Further, the board should assess whether the adviser has developed and implemented reasonable and effective valuation and pricing procedures and whether those procedures are applied fairly and consistently. SEC guidance on how directors can execute these responsibilities suggests that each case will be judged on its own facts and circumstances.

The SEC staff has indicated, for example, that if a board has approved comprehensive procedures which provide methodologies for how management should fair value securities, the board would need to be comparatively less involved in the daily valuation process in order to satisfy its good faith obligation, provided that the board periodically reviews the appropriateness of the methods used to fair value securities and the quality of the prices obtained through these procedures, and that it makes changes when appropriate. Alternatively, when the board has vested a greater amount of discretion in management, the SEC staff believes that the board’s involvement must be greater and more immediate.(4)

In 2008, all investors, including mutual funds, experienced severe volatility in equity markets and an unprecedented liquidity crisis in fixed income markets, particularly for asset-backed securities and short-term financial instruments. As a result, mutual funds, including money market funds, faced difficult valuation decisions. This crisis happened to coincide with the effectiveness of FASB Statement No. 157, “Fair Value Measurements”, which, though not significantly changing the methodology used by mutual funds to value portfolio holdings, created significant uncertainty in assessing how much weight should be given to observed transactions in dysfunctional markets when estimating security valuations. In late 2008, FASB issued FASB Staff Position (“FSP”) 157-3, “Determining the Fair Value of a Financial Asset When the Market for that Asset is Not Active”, effectively codifying a joint FASB/SEC statement issued shortly before. The FSP made three principal clarifications:

1. FASB Statement No. 157 stated that fair values should be based on observed transactions other than those occurring “under duress or [where] the seller is forced to accept the price in the transaction. For example, that might be the case if the seller is experiencing financial difficulty.” As market activity and liquidity declined, various views were expressed regarding observed transactions, with the extremes ranging from a view that the market as a whole (and thus all transactions) exhibited some form of distress and could be ignored for valuation purposes, to a view that without affirmative evidence of distress, all transactions must be accepted for valuation purposes. FSP 157-3 took a position between these extremes, stating, “Even in times of market dislocation, it is not appropriate to conclude that all market activity represents forced liquidations or distressed sales. However, it is also not appropriate to automatically conclude that any transaction price is determinative of fair value. Determining fair value in a dislocated market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.” (Emphasis added.) Even then, applying this guidance has proven difficult, particularly in determining whether sufficient information exists about individual transactions to identify them as “distressed”, and some degree of controversy has continued.

2. FASB Statement No. 157 calls for the maximization of so-called “observable inputs”, which are defined as those “market participants would use…. based on market data obtained from sources independent of the reporting entity”, and minimization of so-called “unobservable inputs”, which “reflect the reporting entity’s own assumptions about the assumptions market participants would use…. based on the best information available in the circumstances”. This requirement had at times been viewed as a bar to adjusting any valuation based on observed transactions for identical or similar securities trading on inactive markets by applying judgmental factors. FASB, however, stated in FSP 157-3 that “[i]n some cases an entity may determine that observable inputs require significant adjustment based on unobservable data….. For example, in cases where the volume and level of trading activity in the asset have declined significantly, the available prices vary significantly over time or among market participants, or the prices are not current, the observable inputs might not be relevant and could require significant adjustment.”

3. FSP 157-3 also reminded preparers of financial statements that price quotations received from brokers may not represent actionable bids, but instead model valuations based on the broker’s own “unobservable inputs” and assumptions. Accordingly, the FSP stated that less weight should be given to broker quotations “not reflect[ing] the result of market transactions”.

When applied to mutual funds, FAS 157 and FSP 157-3 clarified that the mere existence of diminished liquidity in the markets and fewer observable market prices did not necessarily indicate “distressed” transactions, and that in such cases observable market prices continued to represent fair value. In those conditions, accordingly, it would be inappropriate to substitute a “good faith” determination of fair value by a fund’s Board for observable prices. However, if market conditions suggested that the integrity of observable market inputs had been diminished, valuation would require greater judgment and a more robust fair value methodology. Many in the mutual fund industry responded to this difficult valuation environment by:

• Evaluating more frequently the sufficiency of the normal valuation and fair valuation processes and ensuring that the fund's senior management and directors understood these processes;

• Determining that all disclosures about valuation processes are consistent and current;

• Applying more skepticism to and requiring more transparency about model based valuation techniques provided by external and internal pricing providers;

• Using more “back-testing” and sensitivity analysis to determine that valuation biases that may exist in the process are identified and addressed timely; and

• Performing money market fund shadow pricing more frequently.

Looking forward, valuation processes are likely to continue to be a significant area of concern for mutual funds and their boards of directors. FASB also recently has stated that it intends to provide further guidance in distinguishing active and inactive markets, and identifying distressed sales, during 2009, so developments in this area are likely to continue for the foreseeable future.

Liquidity

The SEC defines an "illiquid" security as one that may not be disposed of in the ordinary course of business at its approximate carrying value within seven days. The maximum liquidity threshold, restricting further illiquid investments (but not necessarily requiring disposition of existing illiquid holdings) set by the SEC for open-end funds is currently 15% of net assets (except for money market funds, which have a 10% limit)(5). The determination and subsequent monitoring of illiquid holdings are necessary to determine both compliance with SEC guidelines and the fund's ability to meet redemption requirements on a timely basis. The determination of whether a security is "illiquid" is typically made upon purchase; however, factors affecting both the overall market and individual issuers can change the liquidity of a security over time. Security liquidity and difficulty in valuation go hand in hand. Accordingly, where an adviser manages registered investment companies and portfolios that have illiquid investment restrictions, liquidity determinations should be reassessed periodically, particularly as it becomes more difficult to obtain valuations for particular securities from pricing sources.

One lesson learned in 2008 is that money market funds may need more liquidity than anticipated during a period of extraordinary net redemption levels. Therefore in 2009 the industry and regulators will be seeking solutions to provide this liquidity.

Footnotes:

1. Letter to Craig S. Tyle, General Counsel, Investment Company Institute, from Douglas Scheidt, Associate Director and Chief Counsel, Division of Investment Management, U.S. Securities and Exchange Commission, dated April 30, 2001.

2. See supra note 1.

3. Id.

4. Id.

5. See Revisions of Guidelines to Form N-1A, Investment Company Act Release No. 18612 (Mar. 12, 1992), 57 FR 9828 (raising guideline for non-money market funds from 10% to 15% to facilitate capital raising by small businesses) [hereinafter Release 18612]; Letter from Marianne K. Smythe, Director, Division of Investment Management, to Matthew P. Fink, President, Investment Company Institute (Dec. 9, 1992) (clarifying that change in limit from 10% to 15% does not apply to money market funds); Release 5847, supra note 43, at 7.

6. ASR Nos. 113 and 118, supra note 7; ASR No. 219, supra note 4.located at SEC Financial Reporting Policies 404.04, 404.03 and 404.05 respectively.

7. U.S. Securities & Exchange Commission, Accounting And Auditing Enforcement Release No. 2132, In the Matter of MORGAN STANLEY, Respondent, dated November 4, 2004.

................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download