The difficulty of pricing products makes this focus very timely but investment managers and their third party administrators are also generally very eager to treat customers fairly and need to review established practices to do so. For this reason, we have been asked by members of Investit Intelligence to begin investigating the area of fair value pricing to establish sound practices in pricing bonds, equities, OTC derivatives contracts, property products and funds (for funds of funds managers) for use by our clients.
Volatile market conditions combined with decreased market liquidity makes obtaining accurate prices for the hard-to-value holdings very difficult. Investment managers are under pressure from regulatory and accounting standard bodies to provide ‘fair value’ prices during this stressful market climate, but these financial firms also want to simply treat their customers fairly. Pricing has recently required more intervention from managers and administrators. When fund managers suspect a price in the feeds is not representative of the price they might achieve buying or selling they invoke a set of Fair Value Pricing procedures. Our approach is to see how the number of these occasions can be reduced.
There are difficulties in pricing products across all asset classes but most of our clients are saying they want to concentrate on sorting out data from the bond market and what prices reflect real trades and what prices reflect broker estimates. They need to establish reasonable valuations based on what price might be achieved in a transaction, not some intrinsic value.
Mispricing bonds is a problem for fund managers. The current reality is that the more responsible bond managers who are diligently trying to reflect market prices in their fund’s pricing wouild be at a commercial disadvantage to those who might simply ‘take the price off the tape’ even though the managers might suspect that if they took the fund to market they wouldn’t necessarily get that price. Their performance will look worse.
It is worth pointing out we are talking mostly about funds. When you send a segregated client a valuation it does no more than reflect what price you think the assets would achieve, but when you set a unit price you are saying that is what the firm will buy and sell units at. The problem is that if you have the unit prices set too high, and the fund is in redemption, then you dilute it for everyone who stays within the fund. This is the main reason why it is an issue for our clients and the market in general. Investment managers and their administrators and depositaries genuinely want to provide a fair price to all clients – those who are newly joining, staying or leaving a fund.
A potential solution is to look at supporting technology and services on offer and compare the solutions to the standard feeds the regulators deem as ‘reputable sources’ of pricing data for use by the fund management community. We have already polled our clients about these available third-party evaluation services and they generally felt that the these could be ‘reputable sources’ of useable valuations, which leads us to believe there are partial solutions at hand. There are about half a dozen providers of bond evaluation services and we are are talking to these now. With their blessing, we are comparing their outputs for a range of bonds on an anonymous basis.
The bond market is also more complicated than the equities market because we simply don’t know how many bonds there are and it may be as many as 6mn, not 10,000 (98% of equity world market capitalisation is accounted for by about 10,000 share issues) . Also, almost every bond is different and largely illiquid because large part of the issues are held till maturity. A straw poll taken among our members suggests they would support Europe moving to greater post-trade transparency perhaps using something like the way the U.S. market uses the TRACE approach to provide post-trade transparency. However, transparency comes with some downside in that it may be harder to trade big blocks. The balance at the moment seems to be swinging toward a desire for transparency. However, if bonds are not trading then even if you had a transparent market environment there might be no price reported for them.
The equities story is much simpler because there are reporting requirements for this asset class. The concern among participants in this market was that there is no consolidated tape to catch all transactions at all venues. The other issue is that the information included in data feeds is a ‘touch price’ based on the size of trade that the algos are cutting deals up into. Therefore the feed price does not reflect prices achieved at institutional size. Even since the work started the ease of access to a consolidated tape with information on prices at Standard Market Size has improved. In equities, we may not be dealing with the big difference between feeds and likely prices as we have seen in bonds, but there is opportunity to find a better figure.
In our research so far, we have already started out by setting up some principles for establishing fair value prices. In the coming weeks and after compiling the results of our research, we will be able to provide our clients with a framework of practical approaches to fair value pricing so they can be confident they are providing their clients with appropriate and defensible prices at the level of the portfolio and the fund.
* Investit, a London-based fund management consultancy and research firm, has launched a Fair Value Pricing Working Group as part of Investit intelligence to establish practical approaches for pricing hard to value products and portfolios during these volatile market conditions.