Investors, and the fund managers they invest with, have this year turned a sharper eye toward valuations. The spotlight is firmly focused on OTC derivatives valuations, due to their complex combination of multiple pricing models and data sources. Transparency into the price determination process is now a requirement for sophisticated investors. References to “valuation policies”, “manager marks” and “single source pricing” are now routine during investor due diligence and when making investment allocation decisions. “Consistency”, “suitability” and “verification” are the new watch words.
The era when investors simply trusted the veracity of their investor statements is over – there is a distinct and certain change on the 2010 horizon. Investment committees that previously focused on analysing alpha and risk from investment managers’ figures now demand increased assurance on the accuracy of positions and valuations. The quest for alpha has become, in part, the quest for confidence – “Trust, but verify” became a mantra in 2009. Investors performing due diligence now regularly seek proof that positions are being scrupulously and independently checked with custodians, prime brokers and counterparties.
But how can investors be confident about a fund’s portfolio valuations? For instruments traded on an exchange, supply meets demand and an observable clearing price is objectively determined. But for OTC valuations, price determination is more subjective.
Arriving at fair value can be a painstaking process that requires significant expertise and generates much debate. Ultimately, when all sources have been gathered, derivatives prices can resemble a collection of opinions – judgment is needed to determine which to rely upon.
Valuation Policies
To bring order to chaos and respond to investor transparency demands, an increasing number of funds are implementing valuation policies. Committing to a pricing policy establishes a fund blueprint for consistently applying pricing methodologies and hierarchies, tolerance limits and a process for managing price exceptions. Valuation policies are not absolute, however. First, the policy must be viewed in the context of the investment strategy. As best practices don’t exist in a vacuum, the valuation policy should also be independently assessed in the context of a fund’s strategy and the relative size of its positions and market liquidity. Second, the valuation policy itself should be regularly reviewed and frequently updated – additional data sources, specialised product valuation vendors and market analysts continuously provide new information to the process. Moreover, though valuation policies are designed to apply consistent rules, those rules must be measured against the valuations that result.
Independent Price Verification
In addition to valuation policies, another best practice process is independent price verification, which should be clearly distinct from the role played by valuation vendors. Pricing vendors can provide third-party prices for a specific set of products, and often use proprietary data. Independent valuation services combine this data with other pricing information obtained directly from sources such as counterparties and prime brokers.
As a control against third-party pricing, the valuation verification agent should also calculate its own prices using information obtained independently, as well as positions verified with counterparties.
The valuation service then analyses all price data to identify discrepancies, stale prices or specific directional bias for individual instruments. It should then use tolerance checks which detect unsupportable price changes and disparities among instruments.
Most importantly, through aggregation of all prices on all instruments, the independent valuation specialist facilitates an objective assessment of the total impact on the performance of the fund.
Independence and Transparency
Trust, but verify. Today’s investors and fund managers both increasingly require independent checks in the process of determining accurate valuations. Fund managers must seek robust solutions that demonstrate strengthened oversight and transparency. Independence, clarity and consistency are key requirements of both fund managers and their investors. On-demand, web-based technology can bring fund managers closer to their data, providing granular trade and valuation details. Traders and risk managers can also benefit from improved transparency into the valuation process.
What’s Next
The emergence of new instruments such as carbon offset and life insurance-based derivatives prove that derivatives remain an important vehicle for alpha generation. Investor awareness of valuation risk offers fund managers an opportunity to differentiate their funds, through clearly delineated valuation policies and a demonstrated commitment to the highest standards of governance. The derivatives industry is realising that all the pillars of derivative trade processing support each other. Centralised, integrated, straight-through processes and transparent data are essential. Independent valuation policy monitoring and price verification are proactive steps that reassure investors. Fund managers can then continue to focus on alpha generation.
*Jon Anderson is the global head of valuation and OTC derivatives at GlobeOp Financial Services
