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Fair Value Pricing: Still an IT Hot Spot


Fair value pricing continues to be a red-hot topic for mutual fund advisors as well as for Securities and Exchange Commission examiners.

There is a heightened awareness among investment managers of the importance of fairly valuing securities, fueled in part by the market-timing breaches that are still unraveling, according to the results of a new Deloitte & Touche survey.

Not only have fund advisors taken steps to employ fair valuation processes more often, but SEC examiners are much more apt to question precisely how and when fund advisors dive into fair value pricing mode. The survey polled 63 fund groups managing 2,800 funds with a collective $3 trillion in assets.

The percentage of firms employing independent pricing services jumped more than 300%, with larger firms more likely to outsource that function. A significant 68% of fund firms now use third-party pricing vendors to assess the valuations of foreign securities, up from a minority 21% that used service providers in 2003, according to the survey. In addition, 51% of firms polled noted that over the past year, they have modified their fair valuation procedures or policies.

"The trend over the last two years has definitely been from evaluation [of utilizing fair value vendors] to execution," said Paul Kraft, deputy managing partner of Deloitte's investment management practice.

Fair valuation is the process of determining the proper price for a security where a market price is not readily available. Value often becomes an issue with thinly traded or illiquid securities, or where "significant events" may have occurred, causing a potential discrepancy in the true price of the security at the time that funds price their portfolios. Mispriced securities can skew a fund's net asset value.

Those specific procedures have come under renewed interest among the SEC's staff of on-site inspectors, who are increasingly asking fund sponsors about the adequacy of their policies and procedures for fair valuation. Half of fund firms that had been examined by the SEC reported to being questioned about such procedures.

High on the SEC's List

"It is clearly in the SEC's crosshairs and high on the list of top five topics when they do an inspection," said Robert Dorsey, managing director of Ultimus Fund Solutions in Cincinnati.

After uncovering arbitrageurs leveraging stale fund securities' prices on international funds, the SEC mandated last year that fund registration documents explain the circumstances under which funds will utilize fair value pricing. Before that, the SEC had twice issued fair value pricing guideline reminders to the fund industry, in December 1999 and again in April 2001. But the regulators have left it to each fund group's board of directors to draft policies and procedures that are adequate for their own funds.

However, the SEC has put many procedures, including fair value pricing, under the purview of a firm's chief compliance officer who will now be obligated to test the process that is in place, and by next March, to report on the reliability of the process, said Tony Evangelista, partner and head of the investment management regulatory group with PricewaterhouseCoopers in New York. "Fair value pricing continues to evolve and emerge," he added.

Even where funds tap outside pricing vendors, it is ultimately up to management and the board to decide exactly what events will trigger fair valuation assessments, whether a fund wants to fair value some or all securities at various times, or whether to take no action at all even if a trigger occurs, industry experts said.

The very implementation of fair value procedures is raising other issues, said Ian Domowitz, managing director, analytical products and research, at Investment Technology Group in New York, a major fair value pricing supplier. "It is not just about the fulfillment of the obligation, but what triggers should they be using," he said.

Pricing Evolution

While the recent focus has been on pricing international equities, investment advisors are now considering adopting fair valuation methods for small-cap equities as well, Domowitz said. The Deloitte survey backs up that sentiment, noting that fund advisors are now asking about using similar fair value methods for high-yield bonds, derivatives and even private placements.

Fair value pricing is sure to become a hotter issue for the SEC once hedge funds are required to register, said Janaya Moscony, a principal with SEC Compliance Consultants in Philadelphia. The SEC has expressed concern over hedge funds' security valuations.

In addition, sponsors are asking about adapting fair valuation for Canadian-based funds and offshore funds domiciled in Luxembourg and Dublin, Domowitz added.

FT Interactive of Bedford, Mass., also an independent fair value pricing provider, is developing a prototype that will be available within the next year for European affiliates of U.S. fund companies, said Ken Starr, director of mutual fund services.

The push to get fresh and the most accurate prices possible has even compelled several fund sponsors to shift from using a noon foreign exchange rate in London to obtaining a later foreign exchange rate that coincides with the New York Stock Exchange's 4:00 p.m. close, Starr added.

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