As we’ve pointed out, if one is the worrying sort, hedge funds give plenty of reason to concentrate the mind. It’s not just that they are highly leveraged, unregulated, big, and getting bigger. The Fed has also admitted it doesn’t know what they are up to, which means their reassurances aren’t fact based (how can you give a clean bill of health if you haven’t examined the patient?).
Michael Panzner at Seeking Alpha points to another cause for concern: valuations. He cites an article, “Hedge Fund Valuations ‘Problematic,’ Say Investors,” from ICFA Magazine, which discusses the fact that fund asset values (which are the basis for the calculation of hefty performance fees) are too often set by the fund manager itself:
Nearly two thirds (64 per cent) of institutional investors say that accurately valuing their hedge fund holdings is problematic, according to a new report issued by State Street.
Of those who expressed concerns about the pricing of hedge fund investments, 53 per cent said they were worried because the fund’s general partner was solely responsible for the valuation, while 47 per cent said they were concerned that their hedge fund managers did not employ an independent administrator.
The State Street study argues that mounting pressure regarding valuation is now prompting investors to insist on independent pricing. The possibility of attracting new assets from pension plan sponsors covered by ERISA could also lead more hedge fund managers to adopt independent valuations in the US, according to the report.
In the UK, regulatory and industry initiatives to raise standards for hedge fund valuations have been in the works for years, with the FSA recently throwing its weight behind a set of hedge fund valuation principles developed by IOSCO. The Alternative Investment Management Association also issued a best practice guide on valuations last month.
Despite these concerns the report reveals a booming industry. Nearly two-thirds of institutional investors are now allocating more than 5 per cent of their portfolios to hedge fund strategies, while only 4 per cent have no allocation at all. By contrast, 16 per cent said they had no allocation in the 2006 study.
The difficulty of finding qualified administrators is a serious problem for the industry. Fund administrators often aren’t familiar with all the products and strategies a fund might employ (one big reason is that good staff get poached by the funds themselves). Even if there might be legitimate reasons for a fund providing its own valuation, it’s rife with conflicts. Wall Street firms keep a very close eye on traders who work in exotic or not very liquid markets to make sure their books are marked properly; any market-savvy investor is cognizant of the risks and right to be worried.
These blatant conflicts of interest begs the question of why the investors pouring money into hedge fund coffers. My assumption is that, first, there is a perception that institutional investors need to have some hedge fund holdings, otherwise they aren’t doing their job, and second, they believe that by choosing “good” funds (whatever that means) they will steer clear of any bad eggs.
Storied investor Peter Lynch remarked that the time when stocks were the riskiest was when they were widely regarded as safe. Will the same prove to be true for hedge funds?