The Abracadabra of Valuation - Pension Fiduciaries Beware
Wall Street Journal reporters Susan Pulliam, Randall Smith and Michael Siconolfi fascinate with some interesting statistics about "hard-to-value" assets. In "U.S. Investors Face An Age of Murky Pricing Values of Securities, Tougher to Pin Down; Discord at Dillon Read" (October 12, 2007), they suggest that dollar volumes of securities that don't readily trade now likely outweigh those that do. Their comment that "money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles" leaves one gasping for air. Adding to their assertion that some managers cannot sell at the level quoted by their brokers (quelle surprise!), I've heard through the grapevine that some banks and brokers are no longer willing to quote at all.
So where does this leave pension fiduciaries? The news is not good. If you are a plan auditor, treasurer, trustee and/or member of the investment committee, trying to (a) evaluate current portfolio performance (b) assess external asset managers (c) make changes in the strategic asset allocation mix and/or (d) undertake a risk management program, valuation numbers are paramount. If you are in the dark about what drives asset valuation in terms of identified risk drivers (and their behavior) or know little about how your fund manager addresses pricing, model validation, hedging effectiveness, trading limits and so on, look out. You are smack dab in the middle of the danger zone.
Moreover, if you are relying on a third party intermediary, ask if (a) they play the role of fiduciary and (b) the extent to which they vet managers' valuation policies and procedures. In addition, don't count on your fellow investment committee members to do the heavy lifting. Attorneys confirm my common sense conclusion. "Investing in something you don't understand is a no-no." If only one person on the committee understands the nature of a particular asset class or manager, that's cold comfort in the event of a lawsuit wherein fingers will point to EVERYONE who signed the allocation ok.
Regarding models, they are only as good as the underlying assumptions and how well they map back to reality. Who is testing the models used by your asset managers? Who is verifying the quality of input data? How often are so-called hedges evaluated for economic efficacy? Who is responsible for monitoring the collateral posted by fund managers? Do you have a system that can provide early warning signs that a manager has strayed from his or her stated approach? What needs to be added to your valuation policy (if one exists)? How are you measuring leverage and are your asset managers measuring leverage the same way?
The list goes on...
Valuation is arguably magic if it's arbitrary and capricious. There is an entire industry of valuation professionals at the ready, supported by a large and growing body of knowledge.
Poof or protect? How are your assets doing?
Click here to read one of many articles about model risk.
