Through statistical analysis, the research revealed that comparing the performance of international mutual funds that use fair value adjustments with their proxy benchmark indices can be misleading if the benchmark indices fail to employ fair value principles. The study found that if proxy benchmark indices used fair value principles, tracking error (a common metric in gauging fund performance) for international mutual funds may be significantly reduced.
These findings are contained in a study conducted by Robert Haddad, senior manager of Evaluated Services, Interactive Data Pricing and Reference Data. In his research, Haddad reviewed public net asset value (NAV) data from April 2004 to March 2008 for a sample of 166 U.S. mutual funds investing in international equities, each representing a distinct fund family. Haddad estimated the daily tracking error during this four-year period by comparing the returns of these international funds to the returns of a pair of proxy benchmark indices, with one using local closing prices and the other using evaluated prices from Interactive Dataâs Fair Value Information Service.
Tracking error estimates the standard deviation of the differences between a mutual fundâs returns versus those of a comparable benchmark index. It is often used by fund managers and investors to gauge a level of risk between mutual funds with similar investment styles, relative to comparable benchmark indices. A higher tracking error is generally associated with a perception of higher relative risk in the fund.
Interactive Dataâs findings suggest that if international funds only use benchmark indices that are valued based on local closing prices of international equity securities, an inherent bias toward higher tracking error will persist. This bias is amplified on days with higher market volatility. However, if fair valuation principles are also applied to international benchmark indices, the result is a reduction in tracking error and a more âapples-to-applesâ comparison for measuring fund performance.
âOur research estimates that approximately 93% of international mutual funds employ a systematic approach to fair valuation of international equities,â said Robert Haddad. âThe pervasiveness of this practice among international funds, along with the extensive analysis of fund performance measurements by investors, and the findings of our study, suggest that the mutual fund community can benefit from an introduction of fair value adjusted benchmark indices.â
Currently, more than 160 fund complexes subscribe to Interactive Dataâs Fair Value Information Service, which provides information that can be used to estimate the value of international equity securities after the close of trading in local markets. In 2007, Interactive Data was awarded a patent by the U.S. Patent and Trademark Office for Fair-Value Pricing of a Financial Asset.