Fund managers need help to kick their hubristic habits
After a string of recent hedge fund failures, regulators, accountants and industry groups are growing increasingly concerned about how hedge fund managers value their portfolios.
The problem is especially acute in Asia, where according to a recent survey by the Alternative Investment Management Association (Aima), 62 per cent of hedge funds have no formal policy for valuing their holdings.
That poses big risks for investors. Unlike ordinary mutual funds, hedge funds have more leeway to invest in esoteric and often illiquid financial instruments. Whereas calculating the net asset value of a mutual fund means simply totting up the market prices of the stocks in its portfolio, valuing a hedge fund frequently involves making highly subjective estimates.
Putting a value on instruments such as credit default swaps, distressed debt securities, or complex derivatives might well mean making a call to the dealer that sold them in the first place or even deriving a theoretical value from a computerised pricing model.
This raises a potential conflict of interest. A hedge fund manager may have considerable incentive to exaggerate the value he or she places on illiquid instruments in order to boost the apparent performance of the fund and thus their own performance-related fees.
Aima and its survey partner, PricewaterhouseCoopers, believe the problem is relatively small, arguing that less than 20 per cent of the average hedge fund's portfolio is invested in such hard to value assets. That is a slightly disingenuous point, however, as most Asian funds - 59 per cent, according to the Eurekahedge database - invest solely in plain vanilla equities. It is reasonable to assume that tricky to value assets are concentrated in the remaining 41 per cent, and therefore so are the valuation risks.
The problem is big enough to trouble the Securities and Futures Commission. Launching a consultation paper on revised hedge fund guidelines last month, SFC executive director Alexa Lam stressed the importance of independent valuation to investor protection.
A discussion paper released last week by the Financial Services Authority in Britain singled out the same risk, warning that 'incentive structures, light regulatory oversight and weaker control environments increase the likelihood that hedge fund managers will commit fraud' by issuing false valuations.
With the Aima survey indicating that more than a quarter of hedge fund managers have provided valuations to their third party administrators, Asia's nascent hedge fund industry needs to move rapidly to adopt formal valuation policies in line with industry best practice.
Objective pricing of investments may not prevent future collapses like the implosion this month of Singapore-based hedge fund manager Aman Capital Management, but it will be an important step towards a more professional industry.