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More Funds Applying Fair Valuation

Fair valuation is alive and well and being more proactively and broadly practiced among mutual funds than ever before, according to the results of Deloitte & Touche's fifth annual survey of fair-value practices.

Moreover, the increased use of fair valuation has curtailed market timing by arbitrageurs and increased funds' reliance on third-party pricing vendors and their chief compliance officers and/or general counsel to help in the process.

This year's survey polled 77 asset managers, both Deloitte clients and non-clients, who collectively manage 3,500 mutual funds with a total of $3 trillion in assets under management.

The survey found that an overwhelming 84% of the firms have established fair-valuation policies and procedures to value foreign equities where significant events have occurred after the close of the markets in which they trade. The use of stale prices on foreign securities had presented arbitrage opportunities to some investors and became one of the cornerstone concerns for the mutual fund industry in late 2003.

In addition, asset managers' use of foreign currency exchange rates as of 4 p.m. EST to translate the market values of foreign securities has almost tripled since the previous year's survey, with 55% of respondents using foreign exchange rates, versus 20% in the previous survey.

The result has been a decided decrease in market timing by investors seeking to exploit the stale prices funds often used to price their portfolios. According to the survey, 58% of asset managers reported a decrease in this activity since implementing fair-valuation procedures.

Another key finding of this year's survey is that fund companies have adapted their successful use of fair-valuation procedures for other asset classes, including both small-cap equities and foreign and domestic fixed-income securities.

"After doing a great job on foreign securities, and the lessons learned on significant events, companies are now applying these [fair-value techniques] to other asset classes," said Paul Kraft, deputy managing partner of Deloitte's investment management industry group.

Furthermore, using fair valuation to help price exotic securities, such as derivatives, is also on the rise, albeit still not widely prevalent, the survey found. "More and more fund groups are entering into these types of securities contracts," Kraft noted. But while some derivatives can accurately rely on proprietary models to assist in pricing, there is definitely room for an evolution of data that can help companies price these, he said.

There has been a flood of structured notes and swap products in funds, confirmed Brian Gallagher, a Deloitte partner and national audit leader for the firm's mutual fund industry group. In many cases, funds rely solely on the derivatives contract counterparty to value those derivatives. But according to the survey, more than one-half of fund firms polled employ some type of internal analysis to assess the reasonableness of counterparty quotes and more than one-third of those firms reported detecting errors in those counterparty quotes for derivatives contracts that aren't traded on an exchange.

In many cases, third-party pricing vendors can do a good job of helping with the pricing of more generic derivatives such as swap contracts, Gallagher said. "But if it is a very customized or tailored derivative, that is harder to do," he added. Often, "when a derivatives contract comes home to roost, there are people left holding the bag."

Using a third-party vendor to assist in determining the fair valuations of certain securities has become popular but is not a panacea, the survey noted.

Nearly three-quarters of those surveyed said that they use a third-party pricing service to help in valuing foreign securities. In addition, those third-party vendors are now more likely than ever to pull up a seat in the boardroom. More than half of respondents (53%) said that representatives from those vendors now attend board meetings. This is a dramatic rise from 30% in the 2004/2005 survey and 17% in 2003/2004.

Despite relying on input from pricing vendors, fund companies have become more vigilant about assessing the accuracy of prices independently supplied. More than half of all companies polled, and nearly three-quarters of firms with $75 billion or more in assets, reported evaluating third-party vendor prices. Back-testing the accuracy of assigned fair values has gained importance, and companies, and their boards of directors, will often back-test valuations to determine if the group's fair-valuation procedures need to be tweaked, Kraft added.

Companies are also increasingly incorporating their general counsel and CCOs into the fair-value pricing processes, although the survey found that there is no industry-wide consensus as to how involved CCOs are. "Boards are looking to CCOs to be their eyes and ears, and CCO involvement as advisor to the board [on fair valuation] will be a continued trend," Kraft said.