A new report questions the accuracy of how hedge funds price their portfolios. Model based pricing is identified as the most problematic of three approaches of valuing illiquid securities that are not exchange-traded and therefore do not have a reported market price.

Since there is no standardised approach for valuing illiquid securities, hedge funds can face difficulties in marking-to-market their holdings. The alternative is to rely on their counterparty for pricing or to develop in-house proprietary models. However, by their very nature, proprietary models differ from one hedge fund to another, given that the same model can be interpreted differently based on different valuation assumptions, notes the study by Paladyne Systems.

Hedge funds can value thinly-traded securities by requesting prices from a broker. This raises the question of how the broker has determined the value of the security. Differences can arise between brokers based on the potential variance they apply in the price of the same holdings, resulting in different market values.

Collateral financing

Relying on a single broker or counterparty to establish price is problematic because brokers value a hedge fund’s holdings to calculate collateral financing which could lead to a conflict of interest. In addition, “the prime broker often relies on its internal trading desk for a price, which again has inherent conflict,” warns the report.

The report identifies a number of securities that have proved difficult to evaluate at times of financial crisis, among them, collateralised notes, credit swap derivatives, trade claims and collateralised debt obligations (CDOs). “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,” warns the report. “Investors can be subject to overpayment for units in a fund, increased losses on a sale or payment of inflated performance fees.”

Hedge fund administrators can be one source of oversight with respect to valuation and pricing. The administrator’s responsibility to value a portfolio, however, is limited by its agreement with its hedge fund client and not by an industry standard. A hedge fund manager’s agreement with its fund administrator often does not coincide with a portfolio manager’s interests.

“As such, if a hedge fund values itself at $550m and a fund administrator values it at $500m, the latter has no way to defend its pricing methodology or to prevail. With the ultimate legal responsibility for pricing falling to the hedge fund, many fund administrators may be all too ready to absolve their responsibility.”

Such concerns have prompted institutional investors to demand more transparency in hedge fund pricing in the aftermath of the credit crisis. While the road to standardising valuation methodology may be far off, many hedge funds use a best practice approach to determine the value of their holdings. They gather as many prices as possible from various sources, including broker quotes, data vendors, traders, internal models and independent valuation services and then use an averaging formula to produce a more conservative and transparent valuation.

VB