The increased volatility of markets, the growing incidence of event risks, the heightened levels of political and social instability throughout the world all beg the question if valuations – the bedrock of pension and savings’ funds – are reliable. And there are also questions about real value in the crypto world, an issue that has been painful in recent weeks to many institutions as well as retail investors.
This is not a new question but it is one that we need to consider in the light of the current market environment. Cyber securities are becoming more acceptable to managers, although it is likely that the issues around FTX and others may temper, for a period, that appetite. But even the front runner of the crypto world, Bitcoin, is currently at around $17,000 against a 52-week high of almost $58,000. And Bitcoin has a not insignificant market cap of around $300 billion. And we see volatility elsewhere, with the increased concerns over technology stocks, the politicisation and cannibalisation of the ESG concept and the challenges I recently mentioned in an earlier article of investor liquidity blindness or ignorance.
So, what are the key issues that concern me? First – are fund valuations realistic when only taking current market prices into account? And, if not, what are the alternatives? And secondly, how should we reconcile fund structures to fund values in an age of leverage and hedging?
The markets of today have been marked by volatility and there is definitely a strong correlation between market volatility and liquidity. This is not new and in my early days in this business I recall, on bad news, commenting that the market went lower with wider spreads and smaller sizes. So how does a fund value an asset where they have many multiples of the normal market size? A simplistic regulator some years ago suggested that they should estimate the price on their entire holding. That is a ridiculous suggestion as it replaces one erroneous method by potentially a worse one. Funds do not fire-sell their portfolios other than in the most extreme circumstances, albeit as we learnt in the UK in the LDI debacle, such situations can arise. Many other options have been suggested, often based around historic market data but price indications are not execution prices and so pretty well all of these are flawed.
The most logical option would appear to me to be a hybrid, whereby funds continue to value at the listed price selected but add an indicator of the risk of volatility. This could be based on data such as the FTSE implied volatility index series, although the coverage would need to be broadened over a wider range of assets and perhaps go to greater granularity. That would tell investors the risk, based on history, of prices moving sharply. It has to be stressed that it is just one analytical tool. It does have the advantage of simplicity albeit not necessarily of accuracy,
The second challenge to valuations is hedging and leverage. These concerns have crystallised further following the shock of LDI. A key question is how to control not so much the hedging and leverage but the unintended consequences. It is incredibly difficult to gauge what extreme case should form the basis of the worst possible event. Apocryphal comment at the time of the collapse of the US mortgage-backed market suggests that some firms placed the extreme case at the loss they could support rather than a true analysis of underlying risk. Leverage has always been a two-edged sword. At the height of the hedge fund boom at the beginning of the millennium, multiples in the teens were supported by bankers. It is not surprising that the bulk of them are no longer in business, as some extreme cases saw a wipe out risk from a 5-10% underlying market movement. Perhaps an estimate of wipe out risk is sensible for funds on a regular basis although this is far from simple especially when leverage and hedges counter each other. As we saw with LDI that is not always useful for the practice helped on solvency risk but everyone overlooked demand for prime collateral on sharp market movements!
The markets have changed. Extreme movement short term is more common. We need to ensure investors are aware of the risks of all funds they have an interest in. Communicating that risk is difficult. Assessing it is even more problematical. But it is necessary.