Alternative Valuation Methods: Gaining Importance
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20 October 2010Arin Ray
In the highly competitive environment of investment management business, fund managers have been adopting more risk and trading in increasingly complex products. These include many illiquid instruments, OTC derivatives, trade claims, credit swap derivatives and collateralized debt obligations, many of which are not traded heavily and are seldom reported. As a result price discovery of these products becomes problematic giving rise to extreme difficulties in complete portfolio valuations, even though some data are available from brokers, data vendors and others. Therefore valuation has become a key issue in operational risk management for fund houses. Moreover, of late, a number of hedge fund scandals have been uncovered; though this has mostly been observed in the West, it has attracted world wide attention from both investors as well regulators. Hedge funds usually did not necessarily have to adopt standard policy for valuation of portfolios. But the recent market turmoil owing to the financial crisis has given rise to low or negative returns and high volatility; consequently investors are demanding greater transparency and standardization of policies for valuation. Regulators have also woken up and paid particular attention to valuation of complex products. Using counterparty valuations used to be a common phenomenon among fund managers as it was free for them; however, with calls for greater transparency and standardization, independent pricing is gaining importance. A number of technology and market data vendors are providing this service. In addition to raw and real time market data, they also provide analytics services for pricing fixed income, derivatives and other complex securities. This is mostly observed in the west, but many of these players have global presence and therefore this practice is likely to pick up in Asia in the future. Asset managers, who themselves undertake valuation of complex products on an ongoing basis for their own operations, can also provide valuation advisory services to others; however, there are a number of issues with that approach. Asset managers mostly rely on counterparty valuation or develop their own valuation models in house for pricing securities. As a result, pricing of the same product may differ for different fund houses, even though all the methods used may be fair. As trading strategies and pricing algorithms are proprietary intellectual properties of the asset manager, sharing them as part of advisory services may be in conflict with their own investment interests. Positions taken by other investors based on a firm’s valuation recommendation may actually reduce alpha for the firm’s own clients giving rise to conflict of interest. Conflict of interest can arise internally at the firm level as well, as managers, who derive performance and advisory fee from investment returns, often play an active role in the valuation process.