NAVs - How Much Can You Trust Them?

A growing concern for global markets watchdogs is the accuracy and timeliness of the net asset value (NAV) of hedge funds. The NAV is the ultimate bottom line of a fund, the keystone figure on which performance is based. If the system for setting NAV is not secure, then the fund's worth is suspect.

Today there is increasing pressure on hedge fund managers to improve the protection of investors' interests and to provide more accurate details of real performance. The market's faith in figures has already been hollowed out by the accounting scandals in the United States. After Enron, Worldcom and many others, investors no long trust the bottom line.

Shocked by the tactics of directors of massive public companies and their auditors, the world's regulators are looking for other potential weak spots and, almost inevitably, hedge funds have come into their sights. In standard mutual funds and unit trusts, calculating NAV is a basic operating procedure. The figures are published daily and accepted as the gospel truth, give or take a missed dividend, or an overlooked share capital adjustment.

But what of hedge funds? No longer the domain of high net worth individuals and the sophisticated investor, the growing interest in hedge funds shown by pension funds and the retail market has generated increased demands for accurate and frequently published NAVs.

For vanilla products, such as long/short funds, which make up around 70 per cent of all hedge funds run out of Asia, this should not be a problem. The stocks and derivatives can simply be marked to market. It's when we look at the more esoteric products that the problems begin. How can the true value of distressed debt be accurately calculated or an over-the-counter instrument specially created by a prime broker? How is a highly illiquid stock in a smaller market to be valued?

Even for simple long/short strategies, the value given to some equities may bear no resemblance to the likely proceeds from selling the stock. Asia has many illiquid stocks with nominal prices on screen that would be smashed if any fund tried to sell in large numbers. Or, if a fund has taken the advice of the research house to buy an instrument created in-house and the wheels start to fall off, is the broker tempted to be a little generous in its valuation? The answers to these problems, claim the administrators, is a lot of technology and some common sense.

When the hedge fund industry began, NAVs were provided in the crude manner of telexes and then faxes, between the administrators, brokers and the managers. Today sophisticated programs that automatically monitor underlying assets are being put in place by the specialist firms which have sprung up around the hedge fund industry such as Citco and Fortis Funds, and boutique custodian houses like Bank of Bermuda and Deutsche Bank.

"We used to get faxed statements. The brokers ran the prices against Bloomberg, added up the assets, took away the liabilities, and you had the NAV,' says Ian Lynch, who manages Citco's Asian administration services from Sydney, Australia.

"Today it is completely different. We have electronic links to the prime brokers, and every time they trade, we automatically get a batch file of all their trades. We also get a daily reconciliation of all their open positions, which we then reconcile with the figures on our system," he explains. If any figures don't reconcile, then the administrator alerts the managers.

As well as speeding up the process of NAV calculation, and reducing the risk of errors, new technology has lowered the chances of the sort of fraud which cost Manhattan Hedge Fund investors $400 million last year. The administration manager was accepting faxes, apparently from a broker, but which were forged by the errant Manhattan manager, says Lynch.

"When you're running with proper technology, that sort of thing couldn't happen. The primary information comes from an independent source; it comes electronically from a broker who FTPs (file transfer protocol) a 128 bit encrypted file straight through from one system to another. No fraudster can mimic, say, the Morgan Stanley system," says Lynch.

He notes that standard pricing systems are coming on by leaps and bounds. "We have Bloomberg, Reuters, five or six different pricing sources, and one big database which feeds our portfolio with prices every night, along with foreign exchange, and corporate actions." For Lynch, the whole process of calculating NAV is electronic; the only manual task left is the actual checking off of the process.

The major challenge to administration when setting the NAVs for the more esoteric strategies and instruments, which many of them use, is that they require more work. Lynch says: "We have developed set procedures for this. Everything comes down to the standard of evidence. We will build a file on any stock or position where we have to go further than we normally would." He adds: "This may involve checking back with the manager who the counter party is for any asset, and getting a price, or even going to the market makers."

The last resort is to bring in the auditor of a fund to arbitrate on the value of an asset. Normally, funds are audited once or maybe twice a year, which means regular NAVs are not signed off by the fund's accountants. What concerns some observers of the NAV pricing process is the influence of the prime broker, which will have sold many of the instruments to the fund. In some cases, the prime broker virtually values the whole portfolio, leaving the administrator to subtract the costs of running the fund, and arriving at a final figure once a month, or less.

As full audits of hedge funds take place annually or semi-annually, pricing mistakes can take a long time to show up. Some industry insiders admit that there is the temptation to make a price as favourable as possible, particularly when a spread is involved. "There is room for a broker to price a security as they would wish to price it rather than as it should be," admits one player.

To negate this risk, larger hedge funds now employ two prime brokers, so values are subject to double-checking. An alternative to relying on administrators or the prime broker is for a fund manager to calculate the NAV - not a method that most professionals would like to see. "A good administrator would never accept a manager's price, no one should accept that," comments Bank of Bermuda's director, Paul Smith. He reckons that however obscure an instrument in a hedge fund manager's portfolio might be, there is always a way to get a reasonable value.

"For most hedge funds, we look at them and apply intelligence, use some basic common sense. There are very few prices where we are unable to get some form of confirmation of that price. No prices go through our shop which have not been thought about," claims Smith. He suggests, that if prices are questioned, then those assets should be put forward at regular board meetings, for review by the directors.

Big investors in hedge funds, such as fund of funds managers, have the benefit of "see-through", a regular report on NAVs, which can quickly be compared to other funds following same strategy or investing in the same markets. If a fund's value is moving out of line with its peer group, it quickly becomes apparent, and questions can be asked.

As retail interest in hedge funds grows, similar transparency and regular posting of NAVs will spread the see-through to a wider audience, providing another built-in check for investors.