Hedge Fund Returns - Illusion or Fact?
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Financial News reporter William Hutchings writes that more than a few hedge funds trading in "illiquid" securities engage in smoothing of returns. Citing research conducted by his firm, RiskData CEO Olivier Le Marois says that "instead of following a mark-to-market process to price securities based on what the market is giving for the securities, they are implementing a subjective process of evaluation." While an independent third party could objectively provide an opinion of value or vet the process in place, smoothing empowers the portfolio manager to decide "the value of the securities he is trading." As an aside, for those who invest in hedge funds, consider how many Private Placement Memorandums give a manager full discretion over what and how often positions are valued. (Click here to read "A third of funds hide their true volatility" by William Hutchings, Financial News, July 12, 2007.)
RiskData earlier announced that they would market something called the Bias Ratio. Developed by one of their fund of hedge fund clients, Protege Partners, this approach examines "month-to-month changes in net asset value" against various statistical return patterns, by asset class. (Click here to read "Risk Manager Markets Method To Monitor Hedge Fund Results" by Michael A. Pollock, Smart Money, July 3, 2007.)
On June 27, we wrote that the SEC intends to query hedge funds about their approach to valuing "hard-to-value" assets. Given recent headlines about billion dollar value mistakes, can pension fiduciaries afford not to ask tough questions about process? We repeat what we said then. "In the event of an asset write-down, fiduciaries are going to be grilled about the extent to which they vetted the valuation policies and procedures of hedge funds in which they invested. Absent any documentation to explain the (hopefully thorough) due diligence process they employed, pension decision-makers will squirm. A pretty picture - NOT!" (Click here to read "SEC Announces Investigation of Hedge Funds' Valuation Methodologies.")
In the event that a pension fund hires a consultant or fund of funds manager, are they digging deep into valuation issues? Can they? (As an accredited appraiser, I can vouch for the rigor of training and experiential requirements as regards valuation.) If they don't "own" the valuation oversight duty, who does? At a recent hedge fund valuation workshop I co-led, a colleague read from a fund administrator's client contract, highlighting the section that disclaims responsibility to vet valuation numbers provided by the hedge fund. You often find similar disclaimers from prime brokers and custodians, forcing pension funds to ask - "Who is paying attention?"
If true that valuation numbers from hedge funds are passed through the hands of multiple parties and no one is asking rigorous questions about their quality, aren't pension fiduciaries greatly exposed to liability? The issue is made more complex when various service providers such as consultants play the role of fiduciary.
Answers to questions about valuation should be more than an optical illusion.
