Proper asset valuation is a cornerstone of the investment management process. Without good numbers, it is virtually impossible to make meaningful decisions about asset allocation, portfolio re-balancing, risk control, and manager evaluation. The challenge is especially relevant as endowment, foundation and pension fiduciaries commit billions of dollars to hard-to-value instruments at the same time that regulators are asking tough questions about methodology and process.
Anyone with fiduciary responsibilities needs to have a solid grasp of valuation fundamentals AND understand what happens in the absence of good numbers. The consequences are dire.
Duties extend to assessing external money managers on the basis of their respective valuation processes. (If you get a blank stare, worry.)
1. Do they use independent appraisers or do traders provide their own marks at the same time that they are compensated for reported performance?
2. What valuation models are used?
3. Are they recognized as standard models?
4. Are the models tested?
5. Where does the model input data come from?
6. What systems are used to value individual positions and portfolios?
7. Is model risk well understood and analyzed on a periodic basis?
The list goes on. If a plan sponsor is uncomfortable with evaluating a manager's policies and procedures, hire someone to help. Oversight is a core responsibility and cannot be outsourced away.
There is a lot to say about this subject. I'll be speaking about valuation as part of the (a) Asset Allocation & Risk Management Strategies for Institutional Investors (AARMS
) conference in Boston on May 18 (b) National Association of Certified Valuation Analysts (NACVA
) annual conference on June 2 and (c) Hedge Funds 101 & 102 conference for FRA, LLC
in New York on June 23.
If you are interested in presentations
on the topic of valuation and model risk, contact me
. I'd like to know what keeps you up at night with respect to everything valuation.
Without doubt, there is increasing emphasis on the topic of valuation with respect to both process and outcome.
Valuation is in the news!
"Understand how a fund's assets are valued. Funds of hedge funds and hedge funds may invest in highly illiquid securities that may be difficult to value. Moreover, many hedge funds give themselves significant discretion in valuing securities. You should understand a fund's valuation process and know the extent to which a fund's securities are valued by independent sources." (Hedging Your Bets: A Heads Up on Hedge Funds and Funds of Hedge Funds
, U.S. Securities and Exchange Commission)
"According to a survey conducted by the Alternative Investment Management Association (AIMA) in Q4 2004, 20% of the assets held by hedge funds are hard-to-value securities. But many of these hard to value assets are concentrated within specific strategies such as distressed debt, emerging markets and mortgage backed-securities. Investors in a non diversified hedge fund may therefore have up to 100% exposure to hard-to-value securities. A combination of assets with poor market liquidity, leveraged structures and their non-stable correlation with other related assets mean valuations can exhibit considerable volatility within a short period of time." (Hedge Funds: Are their returns plausible?
Speech by Dan Waters, Sector Leader Asset Management, Financial Services Authority - UK, March 16, 2006)
"The more unusual the instrument or the greater the degree to which the asset payoffs are determined by a tiny fraction of the economic states the harder is the instrument to value and assess the risk." (The Growth of Derivative Securities
speech by Chester S. Spatt, Chief Economist and Director of the Office of Economic Analysis, U.S. Securities and Exchange Commission, December 8, 2005)
"Diligence, prudence and caution should be applied when valuing private companies, and in particular when considering the valuation write-ups of early-stage companies, in the absence of market-based financing events." (Industry Group Releases Clarification Valuation Guidelines Endorsed By ILPA press release
, October 2004) - Note: ILPA = Institutional Limited Partners Association
"Preliminary results from a survey on the pricing of hedge fund portfolio assets suggest that considerably more than one-third of managers mark hard-to-price securities in equity and fixed-income portfolios according to their own models, rather than using dealer's prices." (Model-Driven Pricing Common for Illiquid Securities
, HedgeWorld.com, February 3, 2004)
"Investment Adviser Defrauded Hedge Funds, SEC Suit Alleges" (Derivatives Litigation Reporter
, January 15, 2001)
"Ambiguity clouds valuation methods" (Financial Times
, February 25, 2002)