Two surveys of hedge fund managers’ portfolio valuation policies have revealed a lack of standardization, highlighting a need for stricter valuation procedures, particularly when dealing with hard-to-value assets.
Correct valuations of portfolios are essential if investors are to get information about their exact returns and, on the basis of this, the compensation that their managers should receive. The surveys, by Deloitte and by Horizon Cash Management, point to the need for more work in the area of valuation.
According to the Deloitte survey of 60 managers worldwide, only 47% reported that they used a third party to provide independent pricing valuations. If managers receive compensation based on valuations, conducting valuations purely in house obviously raises questions about conflicts of interest. There is a growing trend towards checking valuations using an independent administrator. However, for hard-to-value assets, often the manager is the best to do so, says Barry Kolatch, author of Deloittes hedge fund study. There is the potential for a conflict of interest, although we found most hedge fund managers do try to get this right. Valuing hard-to-value assets such as credit default swaps, however, can be complicated, and managers should be using a variety of means to check their pricings. The survey revealed that 40% of respondents relied on broker quotes alone to do so. There are many methods for pricing CDS and we think it is more legitimate to use more than one method, says Kolatch. Administrators can rely on the managers to properly value illiquid assets but they should discuss with the manager how it is done and assess the reasonableness of the valuations. A best practice is for discrepancies between the manager and administrator to be worked out and the outcome of those discussions documented.
Hard-to-value assets need valuations checking
Methods used to value credit default swaps
Source: Deloitte Research
The procedure for valuation also seems hit and miss. The survey revealed that while 86% of respondents had a written valuation policy, a little over half of those reviewed their policies only on an as needed basis. Valuation committees have been established by most managers but such committees ranged from just one person to a handful, and the information the committees collected was not, for the main part, used as part of the firms operational risk management. Most surprising, Kolatch points out, was the lack of involvement from the board in overseeing valuations. Of the 28 respondents with boards, 36% had no involvement with establishing their funds valuation policies, and 8% received no information about the valuation policy at all.
A survey by Horizon Cash Management in January also revealed substantial variation between valuation policies among hedge fund managers. Two hundred managers responded to the survey worldwide. Seventy-seven percent of those use an accredited third-party reporting service for portfolio valuation but only 24% perform due diligence on their external pricing sources more than twice a year; 25% check once a year; and 34% never check up on their pricing vendor. I think the industry is being pushed by the investor community in the right direction, says Kolatch. Institutional investors ask for and review the valuation policies. They need to document discrepancies, however, and make sure valuations are being done correctly.
Chris Addy, CEO of Castle Hall Alternatives, a specialist in operational due diligence, says: Valuation is a hugely challenging area for investors funds often hold hard-to-value securities and there is no consensus approach to pricing among either fund managers or administrators. Investors cannot take anything for granted and must understand, in detail, how each hedge fund marks its portfolio and what checks and balances are in place. There is always the danger of performance-smoothing picking prices which help boost measures, such as the Sharpe ratio or, in the worst cases, misvaluation, which is just plain fraud.