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In our work we get to see the valuation practices of a number of buy-side institutions (mutual funds and hedge funds) and IPV depts. of banks. As a general rule we have found that Bank IPVs do have a process that is independent of front-office but the same cannot be said of the buy-side. Best practice as stated in the FCA Handbook says that Investment Firms must have systems and controls for valuation that are documented and that the reporting lines for the dept. accountable for the valuation process must be clear and independent of the front office and must ultimately be to a main board director.
Often the reality is that there is no equivalent to an IPV dept. in the fund and the back-office resource allocated to month-end pricing is spread across a number of different product streams and consequently is more of an administrative function. Often a junior member of the front-office team marks the book and provides his own justifications sometimes with the help of broker quotes which often he is responsible for requesting.
Given the close working relationship between the PM and the trader there is a clear conflict of interest here. Often the trader is asked to provide quotes on bonds he sold to the customer and in order to get future business he will need to support his trades – since his quotes are indicative only there is no trading risk to doing this. The trader also has some leverage in this relationship eg in new issue allocations or preferential looks at interesting secondary trades and so sometimes they can insist the fund pays a fee for the valuations from a separate unit of their bank.
Another issue is that though the provision of broker quotes is important for the strength of the relationship, beyond that they are usually a non-fee earning burden for the trader. In the case of complex and illiquid bonds, if the trader hasn’t seen the bond trade recently, he will rarely be inclined to spend time analysing the bond. Thus pricing on these type of bonds is often very stale. If the trader holds a position in the bond then his valuation will normally be in-line with his offered side, irrespective of where he bought the bonds.
It has been an important part of the post-crisis overhaul to ensure that banks have marked all their assets, especially Level 3, independently and at realistic levels and a lot of progress has been made in this regard. However we believe that regulators should show the same diligence in applying the rules to the buy-side. While it is true that the tax payer does not have the same risk to funds as they do to banks, some funds are large enough to pose a systemic risk.
However more fundamentally than that independent valuations are an important investor protection and it is a blunt tool indeed to say that an investor can sue the fund if he suspects malpractice. It would be far better for the integrity of the market place and to stop problems before they occur to have independent valuation procedures throughout the system.
Of course independent valuations will represent a reduced return to the investor but we think that is akin to a form of insurance which would be a wise investment – not least in giving UK funds a competitive advantage in the global marketplace for investments. At the very least if the rules are not going to be enforced on the buy-side, but individual investors are to be allowed to make their own decisions as to what they insist upon from the funds they invest in, then the rules should be amended to reflect this so that unsophisticated investors do not think they are getting something they are not.