Commentary: Hedge Fund Values: Stop The Fudging

Asset mispricing is the industry's next black eye. Is the SEC doing enough?

Figuring out how much a stock or mutual fund is worth is as easy as picking up the daily newspaper. No such luck with hedge funds. The values of underlying investments are highly subjective. Some high-profile firms, including Beacon Hill Asset Management LLC in Summit Hill, N.J., and Manhattan's Lipper & Co., are already in hot water with authorities who want to know whether managers misled investors about how much their investments were worth. Edward J. Strafaci, a former Lipper portfolio manager charged with fraud and overstating portfolio values at the $4 billion company by the Securities & Exchange Commission, is fighting the charges. Beacon Hill, which allegedly lost $300 million, agreed in November to shift assets to another company while the investigation continues.

The fair market value of securities held by a hedge fund is the basis for calculating its performance. If the numbers are suspect, so are the returns. Moreover, mispricing of the stocks, bonds, and other securities in their portfolios is a significant factor in pushing hedge funds into difficulties. The New York office of Capco, a risk-management firm, found mispricing -- combined with a financial incentive to cover up poor performance and scant regulatory oversight -- had played a role in more than a third of the 115 fund blowups in the 1990s that they tracked. Says Capco partner Stuart Feffer: "Valuation issues will be the next major black eye for the hedge-fund industry."

The SEC is well aware of the dangers. In a report last fall -- part of a yearlong SEC investigation into the $750 billion industry -- staffers rated mispricing as the agency's "most serious concern." Within weeks, the SEC is expected to propose rules that would force managers to register as investment advisers, which almost a third do voluntarily. That doesn't necessarily forestall mispricing, though it requires the disclosure of pricing policies.

That's a good first step, but the SEC should go further. The agency should expressly require hedge funds to retain third-party auditors to validate the valuations they put on the investments they hold. Already, hedge funds get current prices from the brokers who handle their trades, but managers can and often do override the brokers, particularly for thinly traded -- and hard to value -- securities such as bank debt. Capco found quotes from different brokers for illiquid investments can vary by 30%. In the future, managers should have to justify their valuation rationale. At the very least, they should be able to prove that their pricing policies are "conservative, reproducible, simple, transparent, and verifiable," says Rutter Associates partner Charles Smithson, a market-risk consultant.

The valuation problem is likely to get worse as hedge funds continue to attract huge inflows. In search of new investment alternatives, investors poured another $72.2 billion into hedge funds last year, more than in the previous four years combined. As a result, more cash is chasing the same investments, driving returns lower. That has pushed managers into more exotic instruments, such as credit default swaps, bank loans, and mortgage-backed securities. When funds get away from plain-vanilla strategies, such as buying some stocks while selling others short, "you've got a lot of nuance and complexity," says Jim Hedges, president of LJH Global Investments, a consultant for high-net-worth and institutional investors. "And you're playing with fire."

When investors get jumpy about valuations, the consequences can be dramatic. For example, last November, investors bolted when a former trader raised questions about how New York's Clinton Group Inc. was valuing bonds in its flagship Trinity Fund, one of the largest -- and oldest -- hedge funds in the world. In just two months investors withdrew $3.5 billion, about half the fund's assets. Forced to sell assets to raise cash, the fund posted a loss of 21.5% in the 12 months through January, its first decline in about a decade. Clinton Group hired PricewaterhouseCoopers, and says their audit uncovered nothing untoward. Clinton founder George E. Hall promised that the fund would explain more clearly in the future how it values investments.

That's a good start. However, regulators should also insist that hedge funds calculate their values with prices verified by independent sources. Such a step would give investors an early signal about potential troubles. While no one expects hedge-fund values to be listed in the daily newspapers, everyone would be relieved if fewer meltdowns appeared in the headlines.

By Mara Der Hovanesian

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