Hedge funds – now an important component of most institutional investor portfolios – are again coming under scrutiny, this time for their lack of transparency in pricing and valuation. In April, the President’s Working Group on Financial Markets (PWG) called for changes to valuation policies, disclosure, and accounting practices at hedge funds.
In a White Paper being released today, Paladyne Systems and its partners Thomson Reuters and NumeriX, respond to the PWG, and call on the industry to come together in a constructive manner to define consistent pricing and valuation standards.
The paper addresses the issues hedge funds face with pricing, operational transparency and fiduciary leadership. The paper takes the position that it is not just the hedge fund manager’s responsibility to define and adhere to valuation and pricing standards; service providers, data and technology vendors and software analytics providers should all participate in a concerted effort to effect achievable change across the industry. This goes beyond the PWG’s recommendations which, while sound, put the onus back on the hedge fund managers.
Here are some of the key points in the paper:
– Current pricing methodologies are clearly flawed. Any two hedge funds can price the same portfolio differently, and in both cases, the approach can be considered fair and accurate. This high degree of variance by individual managers means the underlying securities in a hedge fund’s portfolio may not reflect the most accurate market values.- This challenge is further complicated by the need for robust technology and operational processes to accurately and consistently value these securities across the industry.- Of all the pricing methodologies, the most problematic is mark-to-model. By nature, proprietary models differ from one hedge fund to another, especially given that the same model can be interpreted differently based on assumptions, or a model can have multiple variations for the same asset.- Mark-to-broker comes with problems as well. Despite complex and sophisticated approaches, sell-side prices are often seen as biased because a broker’s exposures, performance and financing relationships are tied into the same price.- Fund administrators must establish their own pricing procedures, valuation methodologies and hierarchies in order to be a true partner for their hedge fund clients.- The alternative investment industry is making advances, but the most basic element of portfolio valuation “science” is still elusive to most.
Well-documented and communicated operational and pricing processes and methodologies will take the mystery out of pricing.