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What is "Forward Pricing"?
April 21, 2009

Forward pricing is one notable difference between the pricing of mutual funds and stocks. But why is the forward pricing methodology prevalent for pricing mutual funds? And how does it protect the interest of investors? We explore these issues in this article.


Author : iFAST Research Team



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Although there are differences between investing into mutual funds and stocks, there are also some similarities between them. For example, both stocks and mutual funds are investments which carry certain levels of risks and returns. Their prices can rise or decline. Investors sometimes assume that the prices of mutual funds and stocks work in a similar manner. But the fact is, the pricing methodology is one notable difference between mutual funds and stocks.

Stock prices change daily and what investors see are actually prices quoted by another stock seller. If investors put in a buy order, they can choose the price at which they wish to buy the stock, or they can simply choose to accept the market price of that stock. Thus, what investors see is what they get. The transactions take place in real-time, or it will be processed at a later time of the same day if the bid -offer price match.

Pricing of Stocks And Mutual funds Is Different

Things work differently for most mutual funds. First, the price for a unit of mutual fund is called as Net Asset Value (NAV). Second, the most important thing to take note of is that all NAVs are indicative. This simply means that the NAV shown for a mutual fund on a particular day may not be the NAV at which investors buy a unit of the mutual fund. Instead, the NAV displayed will most likely be the latest historical NAV of the mutual fund, which can be one or two business days old.

Thus, what investors see may not be what they would eventually get. Some investors assume that the pricing methodology behind mutual fund’s NAV is similar to that of stocks. This is likely why they do not understand the difference in the NAV seen at the time of purchase and the NAV at which the units were allotted to them by the fund house.

Generally, mutual funds only have one NAV for each day. At any point in time, when investors place an order to buy a fund, they do not know the fund's NAV for that particular day. This is because of the pricing system used for NAV calculation, namely the "Forward Pricing" system. Thus, investors should note that they will not know the exact number of units of the fund they purchase. At the end of each business day, the fund house calculates the value of the fund and it’s NAV, after the market has closed for the day. An investor then receives the appropriate number of units of the fund purchased, based on the calculated NAV and the amount you invested.

Usually, the investor will only get to know the NAV at which he made his purchase the next business day after the transaction date. Thus, at the point of time when investors buy into a fund, it is impossible for them to know the exact NAV they would be getting the units at. Most of the mutual funds sold in India are priced using the forward pricing methodology. In this sense, it does not matter where you buy your fund from, because the processes would still be the same. This is due to the fact that not even the fund manager would be able to know the NAV of the fund on that particular day when the market has yet to close.

To Protect Investors' Interests

Some investors may question the basis behind the forward pricing methodology as it appears to create a fair bit of uncertainty. What the investors are not aware of, however, is the fact that the forward pricing system actually protects their investment interest. Consider this: if the transaction was based on the historical pricing methodology, which would allow investors to know the price at which they purchase their fund, this would also mean that the investors are buying into a market which has already closed. Potentially, there will be short-term traders who would try to capitalise on the price differences to make money from the fund. For instance, if an investor knows that he can buy the fund based on the last business day's price, and he is fairly certain that the underlying market the fund invests into would rise today, he may choose to buy the fund given the knowledge that if he sells the units of the fund the day after, the price of the fund would likely be higher.

Generally, the price gain in a single business day would not be significant, and would be offset by the fund's entry loads. Indeed, to the average investor, this gain would be negligible.

However, High Net worth Individuals (HNIs) could bring in huge amounts of money to the table, and with such immense bargaining power, they may be able to convince the fund houses to accept at much lower or zero entry loads. This would be detrimental to the fund and the long-term investors because the large and rapid inflow/outflow of money does not help the fund. In fact, it would add a fair amount of volatility to the fund's price.

Within the span of one day, the fund manager would not have the capacity to invest all of his money in the portfolio into the relevant stocks he would like to buy into and immediately sell them off the next day. There were investigations into this issue in the United States. The forward pricing methodology solves this problem because no one, not even the fund manager himself, knows the price of the fund at the point when the transaction is being made.

Limited Drawback to Long-Term Investors

Generally, mutual funds are meant to be held for a time horizon of at least three years, if not longer. Hence, it is important not to get too affected by the differences between the prices of funds over the span of one day. It does not matter much whether an investor buys into a technology sector fund today or tomorrow, if the major technology stocks rise by 50% over the next three years. The fluctuation in the fund price due to daily movements would not be significant in this case.

The forward pricing methodology is an important difference between the pricing of mutual funds and stocks. In this light, investors should be aware of the different pricing systems, as well as the rationale behind them. As we have observed from this article, the forward pricing methodology is adopted to protect investors. If investors adopt a mid- to long-term view for their fund holdings, the price differences between what they actually see and what they will eventually get, would not matter so much.

 


iFAST and/or its content and research team’s licensed representatives may own or have positions in the mutual funds of any of the Asset Management Company mentioned or referred to in the article, and may from time to time add or dispose of, or be materially interested in any such. This article is not to be construed as an offer or solicitation for the subscription, purchase or sale of any mutual fund. No investment decision should be taken without first viewing a mutual fund's offer document/scheme additional information/scheme information document. Any advice herein is made on a general basis and does not take into account the specific investment objectives of the specific person or group of persons. Investors should seek for professional investment, tax, and legal advice before making an investment or any other decision. Past performance and any forecast is not necessarily indicative of the future or likely performance of the mutual fund. The value of mutual funds and the income from them may fall as well as rise. Opinions expressed herein are subject to change without notice. Please read our disclaimer in the website.

 


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