The recent recommendations put forward in April 2008 by two private-sector committees established by the President’s Working Group on Financial Markets (PWG) call for much needed changes to valuation policies, disclosure, and accounting practices within the hedge fund industry. Industry experts agree that change is both necessary and imminent, but recognise the significant challenges when it comes to implementing a consistent, transparent and fair pricing methodology throughout the alternative investment management sector.
Hedge fund pricing has always been, at best, a highly inconsistent and unreliable process. The hedge fund industry has never been required to adopt a standard policy for valuing securities, especially the private, illiquid, and over-the-counter (OTC) asset classes. However, recent market volatility and mounting pressure from institutional investors has forced hedge fund managers to focus on the adoption of a standardised pricing and valuation methodology. More recently, the issue of pricing and valuation has escalated to Washington. The PWG has specifically issued recommendations for pricing hard-to-value assets, and has further recommended a formal pricing policy including increased disclosure, risk management guidelines, and operational best practices.
The PWG recommendation does raise the question as to whether hedge fund regulation is imminent or whether the recommendations are just another attempt to nudge managers toward a more institutionalised standard. Regardless, the recommendations fall well short in addressing the deeper industry conflicts in the handling of asset pricing and valuation. The institutional and individual investor communities have also stepped in and are now demanding improved transparency of hedge fund pricing and valuation. Hedge fund managers who do not comply will hurt their ability to attract capital.
The current methodology is clearly flawed. Today, any two hedge funds can price the same portfolio differently, and in both cases, the approach can be considered fair and accurate. This pricing inconsistency is a huge dilemma that must be addressed in order to demonstrate a good faith effort to provide transparency and pricing standardisation to investors and regulators. This challenge is further complicated by the need for robust technology and operational processes to accurately and consistently value these securities across the industry.
This paper explores the hedge fund pricing dilemma in more detail and the need for transparency. This paper identifies the need for a collaborative effort amongst hedge funds, fund administrators, prime brokers, data vendors, and technology providers to define, implement, support and police an industry-wide pricing solution. We predict that the hedge fund industry will join together in a constructive and helpful manner to define a consistent pricing and valuation process which will be accepted by both investors and regulators.
The Pricing Challenge
The root cause of the pricing and valuation dilemma within the hedge fund industry is the lack of any consistent pricing standards. Despite numerous methods of valuation and the existence of sophisticated pricing models, there remains a high degree of variance in the application and selection of pricing methodologies amongst hedge fund managers.
Today, there are three basic pricing methodologies: mark-to-market, mark-to-broker, or mark-to-model. Inconsistencies exist within each methodology; however, the model-based pricing is most problematic. Model-based pricing is most typically used to value illiquid or OTC instruments that are not exchange--traded and therefore do not have a reported market price. Since there are no established techniques or best practices for valuing illiquid securities, most funds either rely on their counterparty for pricing or have developed in-house proprietary valuation models. By their very nature, proprietary models will differ from one hedge fund to another, especially given that the same model can be interpreted differently based on assumptions or can have multiple variations for the same asset.
The establishment of a consistent methodology will be extremely challenging. Illiquid instruments such as collateralised notes, credit swap derivatives, trade claims, and collateralised debt obligations (CDOs) have unique structures and are thinly traded, which makes it very difficult to determine an accurate value. As a result, hedge funds attempt to value these instruments using proprietary mathematical models, or if possible request prices from several brokers and take an average of the quotes. This of course begs the question as to how the brokers come up with a value, but in the end, the valuation of similar instruments differs widely from one fund to another.
The inconsistency of pricing methodology creates a significant risk management problem for hedge fund managers that may ultimately result in legal action. If daily or monthly pricing is inaccurate or inconsistent, not only is it difficult for a fund to measure exposure, but it is difficult to accurately measure a fund’s historical performance. Investors can be subjected to overpayment for units in a fund, increased losses on a sale, or payment of inflated performance fees, all of which can result in legal action and increase the likelihood of regulatory involvement.
In response, some of the larger hedge funds have attempted to document a formal pricing and performance reporting policy; however, fund managers have expressed concern that a valuation document could reveal proprietary trading strategies. To the contrary, a best-practice pricing policy is about the transparency of a firm’s pricing methodology, not its portfolio holdings. If a standard pricing methodology is published and a formal disclosure process is agreed to across all asset classes, a fund’s intellectual trading strategy will be protected since valuation reporting will not be fund specific. Without an industry standard across all asset classes, it could be argued that holdings information could be compromised.
The pricing initiative will become more pressing as investors demand greater transparency in light of the recent market volatility. Traditionally, investors have accepted a lack of operational and pricing transparency, taking comfort that the hedge fund principals and partners have significant equity and personal deferred compensation at risk. However, as more funds have announced negative returns and closings, both investors and regulators are urgently addressing this pricing and valuation issue.
The Need for Operational Transparency
Portfolio pricing is probably one of the most challenging, yet arguably the most important task of any hedge fund operations department. Being able to accurately price the portfolio on a timely basis allows buy-side institutions to properly calculate exposures, forecast fees, report NAV, measure risk, evaluate margin requirements, and most importantly, to calculate performance. Today, the complex, multi-strategy hedge funds with sizeable fixed income and OTC portfolios spend days, and sometimes weeks trying to calculate an accurate NAV. With the emergence of more comprehensive data feeds and third party valuation services as well as the existence of some newer enterprise-wide pricing applications, hedge funds have the necessary tools to make the pricing process more standardised and transparent.
Despite the availability of advanced portfolio valuation tools and specialised pricing services, the complexity of hedge fund trading strategies and asset classes has also increased. As hedge funds try to remain competitive, managers are taking on more risk and trading exotic OTC securities and illiquid assets, such as parking ticket pools, race horses (“Big Brown,” coined as a “hedge fund horse,” just won the Kentucky Derby), surplus inventory of Nike sneakers, art, precious gems, antique violins, and Hollywood blockbuster movies. Even with all the available data from prime brokers, executing brokers, market data vendors, and valuation service providers, the ability to value a complete portfolio, especially one with illiquid assets, is extremely challenging and subjective. One can't help but wonder how these investments get priced, and more importantly how does the pricing logic on those investments get explained if most of them are rarely traded, if at all? These illiquid investments expose investors to significant risk, and in many cases, investors are unaware or cannot quantify the risk. Illiquid securities can drop significantly in value overnight, and, thus, there needs to be transparency and a standard for valuing these investments.
The good news is that most hedge funds do make a concerted effort to conduct accurate portfolio pricing. Most hedge funds are still using spreadsheets to document their pricing processes, with no database or electronic workflow to highlight the process by which prices are obtained and calculated. While spreadsheets are the most inexpensive and flexible tool to utilise for modeling, pricing, and “what-if” scenarios, they do not store and organise a historical audit trail showing how prices have been derived over time. The ability to centrally collect multiple sources of data in a robust manner, determine an ultimate pricing calculation, and report this information on a timely basis, requires specialised technology and skilled staff and is therefore rarely achieved. Some hedge funds have hired a chief risk officer (CRO) to focus specifically on the implementation and oversight of a standard pricing policy. In many cases, the fund’s chief financial officer simply accepts prices offered by the traders for valuation, which presents a clear conflict of interest. The CRO can be empowered to be the final authority on pricing and can arbitrate between the front- and back-office on valuation issues.
For now, without a transparent process and consistent operational approach, hedge funds don’t have a way to prove to investors that their pricing is reliable and market conforming. However, given the availability of new pricing technology, data providers, pricing service providers, and the emergence of the CRO role, the industry is finally in a position to work together to establish a pricing standard, and may be able to preempt strict regulatory oversight which seems to be imminent.
Case Study: The US$100 Million Fund
As discussed, the core of the pricing issue is the existence of multiple pricing methodologies for the same asset classes. The following example illustrates how two identical funds can be valued differently based on their selected pricing methodologies. Consider two hedge fund managers, Aelon and Charter, each holding exactly the same basket of securities. Based on the application of different pricing methodologies and the potential variance in the price used for valuation, the two funds can report very different market values.
Neither fund value is incorrect; however, one could argue one methodology is “more accurate” than another for pricing a certain security type. Which methodology is the right one to use? Investors are demanding an answer to this question and are looking to the industry for answers. In the following sections, we explain the role of prime brokers, fund administrators, data vendors, and technology providers to push the industry towards pricing standardisation.
Paladyne Systems, Inc. (www.paladyne.com), a leading solutions provider for the hedge fund industry, develops and distributes technology designed to streamline hedge fund operations while providing business efficiency and cost savings throughout the organization. Paladyne offers a fully-hosted technology platform known as the PALADYNE™ suite which is capable of supporting the front- to back-office requirements of today’s most comprehensive hedge funds. Paladyne was formed through an acquisition of its technology platform from a large US-based multi-strategy hedge fund.
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NumeriX is the award-winning, independent leader in pricing and risk analytics for fixed income, credit, foreign exchange, hybrids, cross currency, commodities, inflation rate and equity derivatives. NumeriX has a financial engineering and quantitative team composed largely of PhDs on the same scale as the very largest of financial institutions. Trading and risk platform vendors leverage NumeriX analytics to gain a time-to-market advantage by embedding the power of NumeriX into their systems. Founded in 1996, the company is privately held and has offices in New York, London, Singapore, Hong Kong and Tokyo. For more information, visit www.numerix.com.