One of the many operational challenges faced by fund managers as they invest more in OTC derivatives is accurately valuing portfolios containing hard to price instruments, but the good news is that “there’s a lot of experience out there” for firms to tap into, delegates at the recent Optimising OTC Derivative Operations in Fund Management Conference in London were told. Tom Reusch, head of product control at multi-strategy hedge fund BlueCrest Capital Management, reassured asset managers moving into derivatives that “the hedge funds are there already, the large asset managers have gone before – and people are willing to share their best practices and approaches”. “Go back to basic accounting principles,” he advised. “Turn to other experienced practitioners – asset servicers, prime brokers, even auditors.”
The challenges around valuations are significant, he emphasised. How extensive the valuations issues faced will be will depend on a number of factors, Reusch said – “the fund you are looking at, its size, the number of assets, whether it is single or multi-asset fund”. If you are using a variety of sources, they might not be consistent: they may use different models, or not be snapshotted at the same time. The frequency with which marks can be obtained will differ according to asset type, he continued. “For some counterparties and some asset classes it is very easy to obtain marks, but not for all asset classes and counterparties.” Another question to answer is “are you going to value the portfolio on an asset by asset basis and aggregate to the total, or are there occasions when you need to look at groups of assets together?”
Assessing the reliability of data is key, Reusch said, “especially if you are going into derivatives for the first time”: “You can get a feel for the consistency and reliability of data sources.” Counterparty prices are often talked about as the “bedrock of the valuation process”, he added. “You can use them as your primary price and check it using other techniques. At other times it might be appropriate to use another as the primary source and the counterparty as a back-up.” Either way, assessing the reliability of the counterparty mark is essential, he said, and it is important to be aware of likely differences between front and back office provided prices and between “a fair value price versus a systematic price”.
Another headache is reconciliation, he said. “As soon as you get above more than a handful of instruments, reconciling your portfolio with your counterparty becomes very time consuming because of missing data items et cetera.” In an attempt to address this problem, a group of 10 hedge funds and several asset managers have been collaborating since February, he continued. “We meet monthly, and our primary priority issue to address is obtaining and reconciling information from counterparties. We are also working with a sell side group to reach agreement on issues such as the IT requirements, the content, the format and the timescale. The aim is to reconcile early on T+1, consistent with collateral valuations.”
Douglas Hull of the capital markets sector of the FSA urged delegates to get up to speed with the best practice recommendations for hedge fund valuations from IOSCO (www.iosco.org). “The hedge fund community is at the forefront of a lot of change and this has a knock-on impact on banks and asset managers,” he said. “We issued a discussion paper two years ago on hedge fund regulation. We identified issues around valuation practices for hedge funds which concerned us and others.” Hedge fund activities are concerning because they trade the same instruments as investment banks, but without being subject to the same oversight and capital adequacy requirements, Hull continued.
While hedge fund fails leading to investor losses are rare, he said (more often what happens is those that under-perform repatriate their capital), “those that have imploded have had weaknesses around the valuation areas”, he said, adding that “the failures would have been avoidable if there had been an industry standard approach to valuations and it had been followed”. Use of independent prices is a key plank of the principles: the notion of a manager who is remunerated on the basis of fund performance being the sole pricer is completely unacceptable, Hull suggested.
Valuation issues are not limited to hedge funds, he said, and some of those issues also apply to other investors including institutions and high-net-worth individuals. The increased regulatory focus will also have implications for banks, since they are “the food chain” for valuations, he added.
Outsourcing valuations to an asset servicer is one option for asset managers getting into the OTC derivatives business, though Jon Lloyd, senior vice president, global derivatives services business executive at JPMorgan Worldwide Securities Services, warned that any firm with more than 10 open positions will need its own middle and back office functions, so “it’s not a simple outsourcing decision”. “Middle and back office processes are needed within a fund manager to support their own valuations. The fund manager has to perform some activity around valuations – to trade in OTC derivatives, portfolio managers need to value them. There is going to be duplication of effort.” Moreover, firms have to demonstrate oversight of their valuation processes. “You can outsource the process, but not the oversight,” Lloyd said.
Troy Travlos, partner at Investment Horizon, also cautioned delegates about the potential pitfalls of the outsourcing route. Asset managers should beware outsourcing to meet regulatory requirements for independence but without reaping the benefits in terms of operational efficiency and cost reduction, he said. “There tends to be a two-tier cost model, with commoditised pricing for simpler instruments and a different level of pricing for exotic instruments. This means it can be quite expensive to get hold of the exotic instrument prices until you are investing in enough for them to fall into the commoditised box,” Travlos said. Firms also need to be able to get the terms and conditions information for the trades to their outsourcer, he continued. Another important factor for success is for firms not to “just settle on a day one arrangement that meets the initial need but can’t grow with (them)”. “The valuation model has got to be flexible, and a mechanism needs to be embedded in the service level agreement to take on new types of instruments,” he suggested.
Travlos echoed Lloyd’s point that “asset managers need to understand how the price was reached”, and Ian Dando, consultant at Investit, also emphasised the need for fund managers to gain a thorough understanding of the swaps market. “The broker is a source of prices, and when I work with firms I say to them they need to understand what goes on in the inter-dealer broker market. I’m not suggesting that as fund managers you enter that market, but it is important for your traders to understand it, to gain that instinct about the market. This is a deep, complex market that doesn’t stop with the broker: I’m a great advocate of education, and suggest you expose yourselves to more information,” he told delegates.
“If you decide to outsource the pricing of a particular derivative to a third party valuation service provider, they will expect you to challenge them,” he continued. “They’re not perfect.” Specifically, he said, firms should seek to understand the rounding approaches being taken, as rounding is the “bete noir” of reconciliation – “rounding issues between the front and back office systems of investment banks”. Understanding the rounding approaches will enable firms to begin querying the assumptions in the pricing models, Dando suggested. “Firms offering valuations aren’t going to open up to you entirely, but they will have a free and frank conversation with you. If they get more than one client complaining, they will change their models. But to do that you must understand the product yourself. Somewhere in the firm someone has evaluated the price and that is a good starting point. There is knowledge in the firm, and the goal is to harness and consolidate that,” he added.
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