Vendors Call on Fund Industry to Adopt Guidelines for Valuation

May 26, 2008
Chris Kentouris

Three companies are recommending that hedge fund managers and their service providers--prime brokerages, fund administrators and pricing specialists--establish industrywide guidelines for the valuation of portfolios.

In a white paper issued last week--"Hedge Fund Portfolio Pricing Best Practices"--Thomson Reuters, Paladyne Systems, a provider of technology to hedge funds, and NumeriX, which offers pricing and trade analytics software, urge the alternative investment community to adopt consistent pricing standards and methodologies.

A standardized approach would give investors more-accurate net asset valuations (NAV), say the companies, and allow them to better understand how prices are derived for their financial instruments. The need for transparency is being fueled by the institutionalization of the hedge fund industry as pension funds, endowments and insurance companies join the ranks of investors.

"Two different hedge funds could price the exact same portfolio differently--both considered correct and fair," said Sameer Shalaby, CEO of New York-based Paladyne Systems. "The high degree of variance by individual managers means that the underlying securities in a hedge fund's portfolio may not reflect the most accurate market values." Paladyne provides a hosted front-to-back-office service for about 65 funds.

Depending on their magnitude, pricing discrepancies can affect the performance fees fund managers earn--and investors pay. Errors can also have an impact on the fees managers pay their prime brokers for financing activities and margin requirements, which are calculated on the value of assets held as collateral. End investors cannot measure their exposure, or a fund's historic performance, if a NAV is inflated.

At the heart of the problem for hedge funds is how to price their holdings in non-vanilla instruments--such as over-the-counter derivatives and mortgage- and asset-backed securities--for which there is no agreed upon market value. Although mutual funds and pension funds face similar challenges, they are typically less active in exotic products because of more stringent investment policies.

Generally, more illiquid instruments generate wider pricing discrepancies among fund managers and third-party sources. The divergence between a mark-to-model approach and a broker-dealer quote on a collateralized debt obligation or asset-backed security can be as much as 35 percent, say valuation experts.

Hedge Funds' Burden

While the Paladyne-led study favors recommendations made last month by the President's Working Group on Financial Markets (PWG) to improve hedge funds' valuation policies, those proposals put too much of the onus on fund managers, according to Shalaby. "It is not just the hedge fund manager's responsibility to define and adhere to valuation and pricing standards," he said. "Service providers, data and technology vendors and analytics software providers should also participate in a concerted effort to implement change."

Many large fund managers have formal valuation policies and procedures in place, but those address pricing transparency rather than the accuracy of the methodology. "Without a consistent operational approach, hedge funds don't have a way of proving to investors their pricing is reliable and market-conforming," said Shalaby.

Some industry observers question whether the many parties involved will be able to come to an agreement. "I don't see how a consensus can be reached given that the fund manager, prime broker, fund administrator and data vendor are compensated based on the prices they come up with," said Marshall Saffer, VP of New York-based hedge fund administrator Viteos Fund Services.