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Portfolio > Portfolio Construction

Pricing the Portfolio: Questions to Aid Understanding

By Staff Writer

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NEW YORK (HedgeWorld.com)–Several recent events such as alleged mispricing of asset-backed bonds at Clinton Group are pushing investors and regulators to pay more attention to how portfolio assets are valued. This time they have help from the Investor Risk Committee of the International Association of Financial Engineers.

A working paper with a comprehensive list of issues concerning valuation is now available at www.iafe.org. The group advises against one-size-fits-all rules, instead presenting a total of about 170 sets of questions, to be tailored for specific needs.

“We did not rank the questions because the most critical aspects of valuations vary according to, for example, the underlying strategies of the portfolio, asset class, level of internal controls, quality of risk management and staff, and accessibility to management,” explained Leon Metzger of Paloma Partners, who led the IAFE study.

HedgeWorld asked him which one he would choose if he were allowed to raise only one issue with a manager. Mr. Metzger replied that if one could only ask one question, perhaps it might be, “Which questions on this list would you not want to answer, and why?”

It should be more valuable to the investor if this question is answered in a dialogue rather than in writing, he pointed out. That way the investor can ask follow-up questions if the answer is unclear. IAFE discourages turning the document into a formal questionnaire.

Rather, the study is meant to guide investors’ discussions with managers. One general rule it advocates is transparency in valuation policies, practices and procedures. Investors must understand these in order to assess whether an investment is suitable for them, the paper argues.

“Going through a checklist and putting that into your file does not do the job,” says Mr. Metzger. “The more you know the better off you are as an investor.”

Models

Idiosyncratic or arbitrary pricing methods are a particular concern. “Does the firm mark to a proprietary model?” is one of the first questions in the report. “If so, why is that better than the alternatives? What are the alternatives?”

Continuing with this line of investigation, the study suggests looking at how a firm addresses any difference between the price generated by the proprietary model vs. the price realized when the position is closed. “What process does the firm use to seek independent valuations of such trades on a regular basis to compare to internal model results?” it asks.

“There’s nothing prescribed here,” said Mr. Metzger. “All we can do is try to make people more sensitive to the issues. Understanding is the key. It has to be a dialogue and there has to be follow-up questions. You understand better what the investment is if you understand the valuation policies.”

For example, some investors might not know that they’re investing in a fund dealing with illiquid securities. If they ask the right questions, they’ll realize that the investments are illiquid. Others may want to know that prices are stale and why this is the case. Mr. Metzger emphasizes that the issue here is information–there is no presumption against illiquid securities or stale pricing, which may be perfectly acceptable to some investors.

Shocks

“How does the firm react to unexpected shocks as they affect valuation?” is one of the questions. Examples of shocks include the Long-Term Capital Management crisis in 1998 and the mortgage meltdown in 2003. Another item suggests asking how the firm manages any differences of opinion on complex valuation problems.

There are specific issues for discussion with fund of funds managers, such as “What procedures does the fund of funds use to verify the valuations of securities in the underlying funds?” and “Does the fund of funds apply different valuation concepts to different funds in its portfolio?” Additional sets of queries focus on who is responsible for valuation, whether there are conflicts of interest, how debt securities are priced, and the roles of auditors and outside administrators.

Although IAFE started this project more than a year ago, regulators and other government agencies have become particularly concerned with the proper valuation of assets in recent months. Stale pricing of mutual funds is at the heart of the market timing and late trading complaints state attorney generals and the Securities and Exchange Commission have filed against a large number of mutual fund companies.

In the hedge fund industry, charges brought against a former Lipper & Co. manager for overstating the value of convertible securities and Clinton Group’s current troubles highlight this matter.

The SEC encourages best practice guidelines for pricing in its report on hedge funds and studies like this may help the industry agree on some basic principles. IAFE will solicit comments on the working paper until February 27, before developing a final version. Comments can be sent to [email protected].

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