Hedge Funds: Are their returns plausible?
Speech by Dan Waters, Sector Leader Asset Management, FSA
National Association of Pension Funds Investment Funds Conference, Edinburgh
16 March 2006
I don’t think that you would expect a regulator to answer the question presented for this panel directly, and I don’t propose to. But I do want to talk about a topic that will go some way to enabling an answer to be given: namely, valuation of hedge fund assets. Robust and transparent asset valuation practices and policies are things that any pension fund considering investment in alternative strategies must be prepared to look for and insist upon.
Valuing hedge fund positions
Valuations have a special place in the heart of regulators. For many years, and well before hedge funds rose to play a significant part in the financial landscape, regulatory assessment of valuation practices of traditional authorised fund managers has revolved around ensuring that documented and effective systems and controls are in place. Key considerations include:
- clearly defined responsibilities for the valuation roles, with reporting lines independent of the front office;
- independent and reliable sources of market prices;
- regular review of the appropriateness and frequency of independent valuations;
- clarity concerning the timing of closing prices and a robust adjustment process for detecting and addressing mis-pricing errors; and
- robust end of month and, where necessary ad-hoc verification procedures.
From a regulatory perspective, hedge fund investors, like those in traditional unit trusts, deserve equitable treatment across stakeholders. The contributors and redeemers of capital should be transacting at a price which reflects the underlying "fair value" of the assets. There should be consistent treatment too across generations of investors.
When fund managers operate under traditional restricted mandates which may limit their investment universe to listed securities, obtaining independent, fair value prices and an idea of underlying market liquidity and transparency of the valuation process is not, relative to where the strategies of some hedge funds have taken us, difficult.
According to a survey conducted by the Alternative Investment Management Association (AIMA) in Q4 2004, 20% of the assets held by hedge funds are hard-to-value securities. But many of these hard to value assets are concentrated within specific strategies such as distressed debt, emerging markets and mortgage backed-securities. Investors in a non diversified hedge fund may therefore have up to 100% exposure to hard-to-value securities. A combination of assets with poor market liquidity, leveraged structures and their non-stable correlation with other related assets mean valuations can exhibit considerable volatility within a short period of time.
Why are regulators concerned about hedge fund valuations?
All of this may seem to stating the obvious, but how are hedge funds doing in respect of valuing complex and illiquid assets? The answer is mixed, with some particularly poor experiences in the United States. In 2005, valuation related losses in hedge funds were estimated to total $1.6 billion. Poor valuation procedures in combination with weak internal controls were in some cases exploited to misrepresent hedge fund valuations and commit fraud.
Weak internal controls may be exploited in this way within any industry. However, financial regulators and many within the hedge fund industry itself, have been concerned to ensure that the rapid growth in hedge funds occurs with due regard to implementing appropriate systems and controls around the valuation process. This provides the routine protection afforded to investors and counterparties under traditional asset management structures.
Hedge funds operate with economic and financial leverage. Much of that financial leverage is provided via the repo market to hedge funds, from a bank's prime brokerage desk. Performance figures influence the decisions of potential and current investors on whether to increase, decrease or leave their exposure to a Hedge Fund at its current level. Robust, impartial and transparent valuation policies and processes are the key to delivering equitable treatment amongst generations of investors.
You will not be surprised to learn that the FSA, in pursing one of its key objectives of promoting efficient, orderly and fair markets is becoming actively involved in the issues of valuation of hedge fund assets. We are currently undertaking a thematic review of the accuracy of valuations sent by hedge fund managers to their administrators, and are examining the systems and controls that managers have in this area. The work is reviewing the frequency and basis of valuations, the separation of duties between the fund managers and those providing and checking the prices and the reliance that can be placed on third party pricing specialists. It is important to note, however, that hedge funds choose not to incorporate in the UK and we do not authorise the funds themselves. While hedge fund managers operate from London and are subject to our conduct of business rules, the funds themselves have a foreign domicile and are not. If real progress in the area of hedge fund valuations is to be made, it is necessary to address it at a global level.
What progress has there been on developing hedge fund valuation standards?
There have been two recent industry initiatives seeking to raise standards with respect to hedge fund valuations. In April 2005, AIMA published a study on "Asset Pricing and Fund Valuation Practices in the Hedge Fund Industry". In August 2005 the US based Managed Fund Association ("MFA") published "Sound Practices for Hedge Fund Managers".
Drawing upon this work by the Trade Associations, IOSCO, the International Organisation of Securities Commissions is now working with recognised industry experts to develop a set of principles representing good practice for valuations by hedge funds and their counterparties. The industry group includes experts from hedge fund managers, fund of funds managers, prime brokers, auditors, administrators and pricing service providers.
The group, whose work I am chairing, is mandated to develop a single set of valuation principles with a reasonable level of granularity. That may avoid the need for developing additional, potentially inconsistent or duplicative national standards.
But I would emphasise that the role of investors will be particularly important in driving change and raising standards. You may have read about Warrant Buffet’s remarks in respect of Berkshire Hathaway's annual report, released earlier this month. Speaking about winding up a problematic derivatives portfolio, he said that when that task was finally accomplished, his feelings about its departure would be akin to those expressed in a country song, “My wife ran away with my best friend, and I sure miss him a lot.”
The issues highlighted by Mr Buffett - independence of the valuation process from the front office, third party verification of prices and "day one" profit recognition, are all being considered within the IOSCO paper on hedge fund valuation principles. (We are leaving the issue of adultery to the songwriters.)
As investors you'll be aware of the importance of due diligence prior to making an investment. The IOSCO work will assist in establishing what constitute as a minimum, good valuation principles. We envisage that investors will use the IOSCO principles as a benchmark against which to challenge their fund managers and advisers in respect of any proposed investment in hedge fund assets. In saying this I would underscore that we are not warning pension funds not to invest in hedge funds. It is for pension funds and their advisers to determine the appropriate asset mix and diversification for their particular portfolios.
We say instead that investors' interests are strengthened if they ensure that robust and detailed valuation policies and procedures are embedded within a hedge fund. This includes transparency to the investors of the valuation policies themselves. I would encourage you all, when evaluating the suitability of a hedge fund investment, to put significant weighting on the quality of the written valuation policies and procedures which should have been embedded by the hedge fund governing body.
Conclusion
Developing an internationally accepted set of good principles for the valuation of hedge fund illiquid and complex assets should assist hedge fund counterparties in evaluating and controlling their exposures to hedge funds. We believe it will also increase valuation transparency and disclosure for investors. That is the basis for calculating credible performance returns, and hence being able confidently to answer the question presented in this panel discussion.