Fair-value pricing:
Impact on index investing
Walter Lenhard: Fair-value pricing is an adjustment process we use every single
day where we improve the accuracy of the pricing of some international securities
in our funds. What we do is we take the local closing price and we adjust it to a
more accurate price when we value the funds at 4 o’clock, East Coast time. But
this comes up an awful lot with our clients. They ask questions because they
come to us expecting tight tracking for our index products, and all of a sudden
they’ll see the return of our international fund versus the benchmark, and there
could be some performance differences. And a lot of these differences arise
because of fair-value pricing. The indexes actually use the local closing prices,
and our funds update those prices to be more accurate, based on the 4 o’clock,
East Coast time.
International securities close in different time zones throughout the world. And if
there’s a lot of volatility in the marketplace you could see some fairly significant
deviations on a daily basis where we might be 1% higher or 1% lower than the
benchmark. But the good news is as soon as the international markets open up
again, the securities prices will converge so you’ll see much less fair-value impact
over the long term. It’s really more of a short-term phenomenon.
Our international index funds own securities around the globe and different
markets are opening and closing at different times. So, for example, if suppose
when the New York Stock Exchange opened at 9:30 a.m., Eastern time, a British
bank stock is trading at the equivalent of 50 U.S. dollars. When the stock’s primary
exchange in the U.K. closes at 11:30 a.m., Eastern time, the stock is priced at
$55, which is the price used by index providers to calculate their index. However,
at 2 o’clock, Eastern time, new information enters the market, driving share prices
down for many financial service companies. While the closing price of the British
bank stock is still $55, it’s true market value is around $45 at that moment. By
4 p.m., when Vanguard prices our fund shares, the stock’s true market value is
its fair-value price of $40.
So, we need to decide whether we use the closing U.K. price of $55 per share
or the fair-value adjusted $40 per share. Vanguard believes we should use the
fair-value adjusted price because it more accurately reflects the price of that
security at 4 o’clock, East Coast time.
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Meet the speaker
Walter Lenhard
Senior Investment Strategist
Vanguard Equity Investment
Group
So every single day we adjust prices on thousands of different international
securities. We’ve got statistical models that help give us guidance, as to whether
we should be increasing those levels or decreasing those levels. Three of the
most important inputs are really what’s happening in the United States stock
market, what’s happening in the foreign currency markets, and also futures
markets. So, if U.K. futures are up 5%, we’d be more inclined to raise the
price of those U.K. securities by roughly 5%. And what this really does is
protects the long-term shareholder.
So, Vanguard truly believes that fair-value pricing is doing the right thing for
shareholders. There is, however, one side effect. And that’s some temporary
mispricings versus the benchmark.
So, for example, Vanguard Developed Markets Index Fund last year
underperformed its benchmark by 81 basis points, which, on the surface,
seems staggering. But, if you take into account that 70 of those basis points
are due to fair-value price adjustments, the adjusted excess return is just
negative 11 basis points. And if you look back at previous years, this pattern
remains consistent. It’s important to note that fair-value pricing can hurt
performance or it could help performance. The effect is random really
depending upon the start and end dates under consideration.
Either way, the difference due to fair-value pricing tends to smooth out over
the long term. The portfolio management team prides itself on tight tracking
versus the benchmark. And we understand that fair-value pricing can sometimes
be confusing and lead to deviations versus the benchmark, but what we’re really
trying to do is give the most accurate representation of the funds for the best
interest of our long-term shareholders.
Total returns
as of 12/31/2014
15%
10
5
0
–5
–10%
1 year
3 year
5 year
10 year
Since
Expense
inception ***
ratio
NAV*
–5.66%
10.93%
5.29%
4.51%
3.73%
Benchmark**
–4.85%
11.06%
5.33%
4.43%
—
Fair value impact
–0.70%
–0.13%
–0.04%
–0.07%
—
0.09%
Note: Fee adjusted for mutual funds where applicable.
* Effective April 4, 2014, Vanguard Developed Markets Index Fund merged into Vanguard Tax-Managed International Fund, and the combined fund was
renamed Vanguard Developed Markets Index Fund. Performance prior to April 4, 2014, is that of the former Vanguard Tax-Managed International Fund.
The fund retains the same historical performance, portfolio manager, and risks as it did prior to its reorganization.
** MSCI EAFE Index through May 28, 2013; FTSE Developed ex North America Index thereafter. Benchmark returns are adjusted for withholding taxes.
*** Inception date as of August 17, 1999.
The performance data shown represents past performance, which is not a guarantee of future results.
Investment returns and principal value will fluctuate, so that investors’ shares, when sold, may be
worth more or less than their original cost. Current performance may be lower or higher than the
performance data cited. For performance data current to the most recent month-end, visit our website
at www.vanguard.com/performance.
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