How to Price a Mutual Fund? Tediously

On the morning after the stock market’s recent “Blue Monday,” the first thing many investors wanted to know was how well their mutual funds survived the Dow Jones index’s 554-point plunge.

A lot of investors were disappointed--not by the performance, but by the lack of information in their morning newspapers.

Because of the day’s wild action, several fund companies, most notably industry leader Fidelity Investments, missed the daily reporting deadline--leaving some fund prices listed as “not available.”

Fund pricing--the way a fund’s per-share net asset value is set each day--is one of those technical things most investors would just as soon take for granted and not have to think about. And most investors don’t--until the system doesn’t work right.

To get that per-share figure each afternoon, each fund group either does its own accounting or hires an independent firm to crunch the numbers. The data then are relayed to the media.

The fund pricing formula would seem simple enough: Tally the value of everything a fund owns, subtract anything it owes and divide the result by the number of outstanding shares.

That final price is important, of course, because the vast majority of funds sell new shares to investors, or redeem existing shares, only at that closing net asset value, or NAV, each day.

Collecting the data to plug into the formula that calculates that final price is where the real work lies.

Funds start the pricing process in the morning. They tally the previous day’s transactions, monitor the fund’s dividend and interest activity, take an appropriate slice to account for operating expenses, and settle trades--all just to have what they need in place before the market closes.

What’s more, fund accountants track prices to four or five decimal places. The difference between $10.0048 and $10.0051 is one penny per share, thanks to rounding. That $10.0051 becomes $10.01; with millions of shares to account for, those pennies add up.

“Our job is to explain to funds what happened to the price,” says Peter B. Cherecwich, vice president at State Street Bank & Trust Co., a data-cruncher that calculates the prices on nearly 1,300 mutual funds for many different fund companies.

“We get paid to make sure that the NAV is correct, and we spend all day making sure nothing goes wrong.”

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Cherecwich noted that the typical fund will experience one to three “price alerts” each day, meaning some type of event occurs in the portfolio that requires closer scrutiny to make sure that the books are properly balanced.

Once the funds have taken care of the previous days’s transactions and completed the early work, they wait for the market to close.

Final prices on specific securities in fund portfolios come in from various markets, such as the New York Stock Exchange, around 4:15 p.m. EST. That leaves less than 90 minutes to determine funds’ closing prices and report that data to the National Assn. of Securities Dealers for distribution to the media.

It’s in the last few hours of the day that things get tricky on many levels.

Some funds have hundreds of holdings. It usually is easy to know the value of something on the New York Stock Exchange. But valuing a security from, say, Hong Kong, is a lot more involved.

Within parameters set down by regulators, “each fund sets its own rules in its prospectus, on how it is going to price some of these things and the tolerances it will accept,” says Glenn P. O’Flaherty, director of fund accounting at Janus Funds in Denver. “The rules determine exactly how the fund does its job, deriving a fair value in good faith.”

Individual fund-company pricing policies became an issue in the aftermath of Blue Monday.

Fidelity reported that its Hong Kong & China fund gained 0.2% on a day when the Hong Kong stock market--and many Asian stock funds--dropped by more than 10%.

The Fidelity fund’s NAV was calculated by “fair-market value pricing,” a method that essentially allowed Fidelity to account for the time differences among world markets, and price the fund not based on the Hong Kong market’s decline, but based on how securities with ties to Hong Kong fared in the United States and Britain before the Hong Kong market reopened.

One goal of fair-market value pricing: to confound short-term market timers trying to “front-run” markets based on action around the globe.

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The Securities and Exchange Commission, which allows Fidelity and other fund companies to use fair-market pricing on thinly traded issues, plans to review the rules because of the firestorm generated by the Fidelity case.

The valuation method notwithstanding, fund accountants must have every security priced so as to come up with an NAV for each fund by 5:40 p.m. EST. Missing that NASD deadline--it was pushed back to 6:10 p.m. on Blue Monday--means a fund’s price will be listed as unavailable.

Finally, a fund re-checks its price and sends the legally binding price to the transfer agent, the firm that processes shareholder trades. That’s usually, but not always, the same price you will see in the next day’s paper.

All told, most fund accountants say the numbers in the newspapers are correct more than 99.7% of the time. “Not availables” count as errors. The price given to transfer agents is right nearly 99.9% of the time.

“If I were opening the paper and saw that a price was not available, I wouldn’t worry or feel bad,” says David Spina, State Street’s president. “I’d call the fund company; they should have it for you. The important thing is that the price is correct and that you have access to it one way or another.”

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Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached at the Boston Globe, Box 2378, Boston, MA 02107-2378, or by e-mail at jaffe@globe.com