A tale of two NAVs

Industry experts are scrambling to minimize confusion over the way mutual funds calculate their daily net asset value.

Investors, mutual funds and advisors want NAV calculated the way it has been — based on daily closing prices — while accountants want NAV calculated based on bid/ask prices.

Changing the way NAVs are calculated creates a whole host of problems for the mutual fund industry. At what price are funds bought or redeemed? How will bid price be tracked? And what will prevent someone from manipulating the value of a fund by placing artificially high asking prices on the securities it holds?

While consultants and regulators hammer out a solution, fund companies like Front Street Capital seem resigned to the reality of the situation. “We take direction from the regulator. If they tell us to jump, we say how high,” says Front Street’s CEO Gary Selke.

Selke is clearly frustrated with the predicament the industry faces. “I didn’t know the system was broken,” he says. “It’s consistent with acting before thinking.”

The move seems to cut against the grain for an industry aiming to improve transparency. “I think it has the potential to cause confusion,” concedes James Loewen, KPMG’s national director for investment management and funds practice, “but there are things that can be done to mitigate that confusion.”

As different as the two approaches are, the issue was never intended to impact the mutual fund world. But those good intentions went awry in 2005 when a last minute change was made to the continuous disclosure requirements. In a late draft of NI 81-106, regulators added the idea that a reporting issuer or investment fund had to strike their NAV in accordance with GAAP.

No one paid much attention to the point at the time because no one had any issue with Canadian GAAP, says Loewen, who is also a member of a Canadian Institute of Chartered Accountants study group examining financial reporting. Everyone is paying attention to it now.

In early 2006 the Accounting Standards Board of the Canadian Institute of Chartered Accountants opted to replace Canadian GAAP with International Financial Reporting Standards. The move required mutual funds to calculate their values based on bid/ask prices rather than the closing price of securities for financial statements.

Although the change was meant only to impact the financial statements, it quickly became apparent that clause in NI 81-106 meant it would also impact daily pricing. It’s an unintended consequence, says Loewen.

“It is an accounting standard, it was never meant to govern how somebody would price for people buying and selling the fund,” he says. “Accountants like to be conservative and bid prices tend to give you the conservative result.”

The new rule says investments that are carried at fair value for actively traded securities have to be priced at bid. Funds that ply their trade in illiquid securities will likely experience the greatest gap between NAVs calculated on bid/ask prices versus closing prices.

Countries like Ireland and Australia have already grappled with the issue, says Loewen, but they were able to maintain their pricing regimes when the financial statements changed because they didn’t have the same regulatory standard that makes this an issue in Canada.

Despite the problem, Loewen has little sympathy for the regulators who are left to resolve the situation. “A regulatory standard should never be tied to something like GAAP because it changes over time,” he says.

Loewen is confident that nothing will change from a pricing perspective for mutual funds. Still, mutual fund companies and investors will have to become accustomed to digesting two NAVs for the same fund. For the most part, pricing NAV will be reported in all places except for financial statements, Loewen says, but in financial statements there is going to be a requirement to reconcile accounting NAV with pricing NAV.

On Oct. 1, 2006 the OSC granted the industry a one-year reprieve to continue to price NAVs with closing prices. The industry has until October to come up with a solution, but Loewen says he expects the CSA will have a proposal on how it plans to proceed within the next few weeks.

Oddly enough, there is a chance the accounting standards could change again when the U.S. moves to harmonization, says Loewen. “Who knows what the end state of accounting is going to look like as it relates to investments because in the U.S. this is not an issue because the accounting rules allow for closing price.”

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(01/23/07)