It is crucial for investors to understand the valuation procedures used by a fund before deciding to invest in it. But the less mainstream the assets held, the harder they are to value, says Dermot Butler
The most critical factor in calculating the NAV of hedge funds ' or indeed any fund ' is the accurate valuation of the underlying assets. For traditional mutual funds and unit trusts, which, for the most part, are long only investing in liquid securities, listed on major exchanges, this is a relatively simple matter, as indeed it is for a major market long/short hedge fund ' you tap into Bloomberg and the computer does the rest. But life is not always that simple.
Problems can occur when investing in funds of funds, illiquid securities or the more esoteric derivatives, which can be difficult to value without a combination of experience in the relevant market and sophisticated models.
The other problem area is one of perception with regard to the independence of the valuation process. Many recent hedge fund scandals have occurred because the hedge fund manager has been able to manipulate the prices of the underlying investments. In most cases, this has only been possible with US hedge funds, where it is common practice for the manager to administer the fund. Offshore funds, on the other hand, are rarely self-administered, unless by default, which can occur where the offshore fund is investing as a feeder fund, through a master-feeder structure, into a self-administered onshore master fund. On the other hand, some offshore fund portfolios are valued (if not fully administered) partially, if not completely, by the manager. With some of the more unusual investments this may be unavoidable, but I believe it is essential that the valuation process should never be the sole responsibility of the manager and that some independent verification procedure should be put in place, whereby the administrator, prime broker and/or the auditor is involved in the valuation process.
Of course, the majority of managers are honest individuals, but in today's nervous investment arena, perception is key and reflects the old adage that it is not just doing the right thing, it is being seen to do the right thing that is important.
Effective involvement by third parties in the valuation process can avoid the heart-paralysing situation that occurred for some investors in David Askins' Granite Partners fund, which collapsed in 1994 after the interest rate spike of that year with losses of some US$600m. Presented as a market- neutral fund investing in mortgage derivatives, Askins continued to value the fund on what he contended were reasonable prices for the derivative positions the fund held, presumably based on what he deemed to be the maturity values, as opposed to current values. He reported these valuations to investors, which indicated that the fund was still performing well. However, the prime broker disagreed with his pricing model and demanded margin security, which could only be provided by liquidating positions. It was this liquidation into an unreceptive market that devastated the fund. And long-term capital suffered a similar situation four years later.
Examples of the more tangible problems that I refer to above, are many and varied and include, inter alia, funds of funds, funds that invest in emerging markets, restricted stock, private equity, venture capital and, of course, esoteric derivative contracts.
The problem with funds of funds is simply the time it can take to get the valuation of the underlying funds from the relevant fund administrators, whilst contending with the understandable impatience of investors in the fund of funds, who wish to know what their investment is worth. The final confirmed NAV of some of the sub-funds could take six weeks or more. This presents a quandary ' should the fund of funds be valued on the basis of the last known valuation, which could now be over a month out of date, or should the administrator wait until he has verified NAVs before publishing a valuation for the fund of funds? As a general rule, there are usually only one or two funds that are consistently late with their NAVs and therefore a decision has to be made whether to accept the managers' estimated NAV for those funds and publish an estimated NAV for the fund of funds as soon as practical, with the proviso that the final NAV will be published when the final figures come through. However, it is inadvisable to do this, unless the manager giving the estimates can demonstrate that they have consistently provided accurate numbers that have not resulted in any material change in the valuation of the fund when the final verified figures come through.
• Problems can occur when valuing funds of funds, illiquid securities or the more esoteric derivatives.
• The valuation process should never be the sole responsibility of the manager.
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