Professors Nicolas Bollen and Veronika Pool researched why hedge fund managers seemingly lean to the upside when placing value on their underlying assets – in turn both boosting and smoothing monthly returns and often accompanying Sharpe ratios. …

The suggestion that hedge funds are improperly inflating their returns by brandishing higher than deserved valuations on their more obscure assets has received much attention. …

Pool and Bollen analyzed monthly returns between 1994 and 2005 from more than 4,268 live and defunct hedge funds with varying investment styles using simulated algorithms with random variate inputs, flow-performance-relation factors and other multifarious techniques. …

… more complex derivatives and other packaged securities have emerged, particularly in the hedge fund world, more managers have shifted to a “mark-to-model” approach.

Mark-to-model mythology

“Mark-to-model is garbage,” said Espen Robak, president of Pluris Valuation Advisors, LLC, which specializes in valuing restricted securities and other illiquid assets. “These models are basically consensus or some kind of theoretical model that has never been tested. As soon as you see stress in the market, you see delta.” …

The issue of valuing complex and illiquid securities and how those values affect bottom-line returns has caught the attention of regulators. Before the summer market crunch, and in ht wake of its quashed attempt at additional hedge fund oversight, the U.S. Securities and Exchange Commission (SEC) passed an amendment to Section 206(4) of the Advisors Act, clarifying that it is unlawful for investment advisors to “engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative.”

The SEC also spelled out that it could “prescribe means reasonably designed to prevent such acts, practices and courses of business as are fraudulent, deceptive or manipulative,” not just to registered investment advisers but to all advisers.

“Under those rules, inaccurate valuations may constitute fraud, whether or not the intention was there to misvalue,” says Robak, whose firm focuses on the private investment in public equity space. “It’s a new rule and nobody knows how it’s going to be enforced.”

Robak says the rules make it clear that managers need to have a fairly valued exit price. To ensure that’s the case, many of his clients have been following guidelines established by the Federal Accounting Standards Board (FASB), which has put forth as clear a definition as it can muster of what fair value is and what methodologies should be implemented to get it. A growing number of hedge funds are turning to level three of the rule, which spells out how to reconcile recurring fair value measurements. …

No perfect solution

What virtually all experts agree on it that most likely there won’t ever be a universally standard, “perfect” way to value all illiquid and complex assets – because of the constant changing nature of complex securities, because of differing opinions on how those securities should be measured and because of human nature.