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Tuesday July 06, 02:47
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Donaldson questions fund pricing
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William Donaldson, chairman of the Securities and Exchange Commission, has said the way in which hedge funds value their portfolios will be a key issue for the US regulator to look into.
The move highlights what is probably the most fraud-prone area of the $800bn industry.
Hedge funds are increasingly trying to lift returns by focusing on lower-grade debt, often traded over the counter, and asset-backed securities. However, these securities tend to be thinly traded and illiquid, making it difficult to value them correctly. That makes it easy to assign an inflated value to them and thus inflate returns and profits.
"The pricing of hedge fund shares is clearly an issue, especially given the compensation," Mr Donaldson said last week, when he also mounted a robust defence of his plan to force hedge fund managers to register with the SEC.
Managers take 20 per cent of their funds’ earnings, which gives them an incentive to increase the profits.
In a recent study of 100 failed hedge funds, Capco, a risk management group, said: "We have found numerous occasions where, on the back of poor investment performance, managers ’modified’ the valuation of their funds . . . to buy time until actual results hopefully improved."
The valuation issue would be the "next major black eye" for the rapidly growing industry and hedge funds would face a crisis of confidence among investors if they did not improve their valuation practices, Capco said.
The company pointed out that some strategies were more susceptible than others. Funds specialising in convertible bonds, mortgage and asset-backed securities, distressed debt, credit and over-the-counter derivatives were all prone to mis-pricing, it said.
Most hedge fund collapses in the past three years have been the result of mis-valuations of the assets. In their report last year, SEC staff said the valuation issue was one of the most serious concerns they had about the funds.
The SEC last month charged the four principals of Beacon Hill, a New Jersey-based hedge fund, with fraud, saying they overstated the value of their funds’ portfolio by $300m.
In 2002, Lipper Group collapsed after failing to correctly value its funds - mostly convertible bonds.
Barry Colvin, president of Tremont Capital Management, a hedge fund group, said: "This [valuation] issue has been around for a while. There will always be securities that are thinly traded and it’s these securities that show the best returns. For years the managers have assessed the value based on their market knowledge but you never really know until you sell them."
Funds use their broker, fund administrators and/or a third-party valuer to price their assets. However, even these can get the prices wrong, making mis-pricing fairly common, even among funds who work hard to get their valuations right.
Broker quotes for mortgage-backed securities and municipal bonds can vary by up to 30 per cent.
Mr Colvin said the industry best practice was to have prices checked by someone other than the portfolio manager, and also by an outside administrator, to show up any pricing variances. Larger funds could also hire a third party risk expert.
However, he said a third party, while less likely to commit fraud, could be more likely to get the prices wrong, because they are less in touch with the market.
The controversial SEC vote on whether hedge fund managers should register with the regulator is likely to be held in the next few months - it appears likely to be passed by three to two votes.
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