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What’s the Formula

In the quest for higher returns against the backdrop of flat equity markets, pension fund managers are turning to hedge funds in increasing numbers. Consultants Watson Wyatt and Psolve Asset Solutions confirm this trend, though precise numbers are not available for rates of hedge fund allocation.

From among the highly technical and sometimes exotic strategies offered by hedge funds, both firms suggest their fund management clients should choose a ‘fund of funds’, where they can gain exposure to a variety of investment strategies and hedge fund managers under one overall manager.

The attraction of hedge funds is that they offer active management of funds in an unregulated environment where they are able to apply strategies not open to the conventional fund management industry, such as short-selling and a high level of leveraging. The goal is exceptional returns in exchange for the high level of fees that hedge fund managers demand.

There have been some notable recruits to the hedge fund approach – BT and RailPen among the most noteworthy – but the big question is, is it worth it? Average hedge fund returns as illustrated by MSCI’s Hedge Fund Composite Index for the year to date announced 23 July 2004 show between 1.6% and 2.3%, depending on how the index is weighted. Not exactly stratospheric, but as Chris Mansi, Watson Wyatt’s head of the hedge fund research team, points out, these are calculations of average performance. Moreover, not all of the 6,000 or so hedge funds in existence reveal the levels of their returns. In addition, the object of the exercise in using hedge funds is to choose skilled managers who can really outperform.

Pension fund managers opting to put part of their portfolio with hedge funds need to be able to know the exact value of their investments at any one time in order to fulfil their fiduciary duties. This, however, has become a hotly debated issue.

Valuation of positions can take many forms. Marking to market positions where the underlying assets are traded in liquid public markets is straightforward. A difficulty emerges when they are in illiquid areas, among which can be certain emerging markets, distressed securities or over-the-counter derivatives. In such situations, accurate valuations are often difficult to achieve.

If this seems like a matter of marginal importance, then it is worth considering that hedge funds may now account for global assets of as much as $1 trillion, and that they play a significant role in providing liquidity to some financial markets.

Christopher Rose of Lombard Risk Management, a financial trading and risk management software and services provider, points out that some valuation methods are less satisfactory than others. In the US, for example, it has been common for hedge fund managers to provide their clients with their own valuations, whereas in Europe third-party administrators provide them.

The concern is that as hedge funds proliferate, and their use by mainstream asset managers increases, they remain unregulated: there are no market-wide valuation standards and a low level of transparency to their activities. Further, as interest rates rise, hedge funds that have profited from borrowing cheap funds may find their investment strategies unsustainable and become unstable. Perhaps this is acceptable if unregulated hedge funds are providing services to wealthy and sophisticated private clients who understand the risks they are taking, but questionable when workers’ pensions are being invested.

Another worrying feature derives from the sheep-like nature of the financial sector. History has shown that not only do early entrants to new markets make real profits but that when later lenders and investors arrive in numbers, returns are mediocre at best, and money is lost at worst – sometimes a lot of it. The point about valuations is that they provide warning signs and help investors to manage their exposures. Inadequate reporting can contain a disaster waiting to happen. l

Hedge funds are not formally required to value their positions any particular way. Under IAS 39, however, listed companies will have stricter obligations.

– Hedge funds can obtain a buy-back valuation from their original counterparties. May not be true market value. Companies may be able to use this metric though it may only reflect a particular counterparty’s view.

– Value positions at purchase price; obviously unsatisfactory, but an option. Would not reflect current fair value.

– Use a fair market model prepared by an independent third party. Often applied to over-the-counter instruments. Appropriate for use by companies.

– Use the hedge fund’s own valuation model, validated by an accountant or other acceptable third party. It is unlikely that any but the large corporate users of derivatives – eg, banks, largest multinationals – will have their own model available.

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