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Increased Sophistication of Triggering Strategies Being Applied for Fair Value Within Mutual Funds

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Interactive Data’s recent survey indicates that its mutual fund clients are using increasingly sophisticated triggering strategies to determine whether to apply fair value methodologies to their global equities. Reference Data Review speaks to Rob Haddad, director of Evaluated Services at the data vendor, about the trend towards multiple benchmarks and trigger levels and the increased use of fair valuation methodologies overall.

As Haddad noted back in 2009, increased market volatility in the post-crisis environment has had a significant impact on the valuations sector in terms of methodologies and the frequency with which fair value is applied. “We did observe somewhat more sophisticated triggering strategies than we have seen in the past. Some funds are using multiple benchmarks and trigger levels to invoke their fair value procedures,” explains Haddad of the recent survey, which involved 134 individual clients from 111 mutual fund firms.

The motivation behind the vendor’s recent survey was to gather information from the mutual funds industry as it relates to fair value practices such as the concept of triggers. “One of the most talked about issues amongst mutual fund boards is how often they should invoke fair value practices,” he says. “Certainly the volatile markets that we are experiencing right now make the fair value process that much more important.”

After all, the increased volatility in the market is a catalyst for more frequent fair value pricing amongst funds, especially when funds may encounter their trigger levels being exceeded nearly every day. Picking the right triggering strategy and benchmarks is therefore critical to the whole process.

The results that Interactive Data saw from the survey met the vendor’s expectations, according to Haddad: “For example we found that around 36% of the funds that responded were using a zero trigger, or fair value every day approach for global equities. The remaining 64% typically selected a particular trigger level in a relevant benchmark to take note of, for example the S&P 500 index futures happened to be one of the most popular benchmarks.”

Explaining how such a strategy might work, Haddad elaborates: “They might look at the movement in the S&P futures from Tokyo close to New York close and if that movement exceeded a certain threshold, such as 50 basis points in either direction, that would ‘trigger’ them to invoke fair value adjustments to those securities.”

Although the survey is a snapshot of what the vendor’s mutual fund clients are doing right now, Haddad indicates that the vendor is comparing the results to previous efforts. “We look at this information with respect to some of the surveys that we have done before, for example a survey conducted during a webcast in 2009. We asked similar questions about fair value practices then and in 2007 we authored a white paper on trends in fair value usage and trigger levels, which was more of a study based on quantitative estimates,” he says.

On the subject of historical insight, Haddad notes that the back testing process can provide funds additional insight into fair value pricing. For instance, if mutual funds are evaluating their current fair value practices, they might decide to back test to examine how the fair value performance might have played out under different circumstances. For example, this could include reviewing the performance differences on their portfolios between a zero trigger and 100 bps trigger, he explains. “We do find market volatility as being the predominant trigger to invoke those procedures.”

There has also been a definite increase in fair value calculations, he continues: “During a study we conducted in 2004, we identified that around 10% of the mutual funds were employing a fair value everyday approach using a zero trigger, but now that has increased to 36%. There was a noticeable trend towards more frequent fair value practices over the years, although we have seen that level out somewhat. We have also seen lower trigger levels being used more frequently.”

He indicates that it was important for Interactive Data to get some information about back testing and the vendor found that 92% of the respondents employ a systematic back testing process to support their use of fair value. “Our experience shows that this review process is a great way to identify whether any adjustment to fair value procedures are needed,” he says.

As far as takeaways, Haddad believes it is really important to continually review the marketplace and see what other mutual funds are doing. Trend spotting is a key factor of this: “We saw participation from large firms and smaller mutual funds, but there did not appear to be any correlation between trigger level or benchmark usage and the size of the fund.”

All of this information is also being fed back into the vendor’s own market strategy. Interactive Data’s Fair Value Information Service has been available for the mutual funds industry since 2002, so for about nine years it has had clients using the service to evaluate international equities. “The survey results highlight that we need to continually be prepared to support our clients on issues concerning fair value practices, whether it is sharing our observations in the marketplace or assisting our clients in performing a variety of back testing strategies to gain comfort in their process,” concludes Haddad.

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