Valuation Issues in Alternative
Investments
Neil D. Pearson
Instruments Traded in “Two-Way” Markets
• Some “alternative investments” are strategies that involve
instruments traded in liquid “two-way” markets
– Equity long/short strategies
– Managed futures
– Some currency investments
• A “two-way” market is one in which both customers and
dealers are both buyers and sellers, e.g. the NYSE
• The trading strategies might be complicated, risky, and/or
difficult to understand, but the portfolio valuation is
usually straightforward
• E.g. exchange-traded equities or futures are valued at
exchange closing prices or futures settlement prices
2
Instruments Traded in “One-Way” Markets
Other investments are illiquid and/or traded in “one-way”
markets
A “one-way” market is one in which the customers are
always (or usually) the buyers and the dealers or other
financial institutions are always (or usually) sellers
Examples:
•Structured equity (or currency or commodity) products
•Distressed securities
•CDO tranches
•Private equity investments, …
Valuation issues are important for such products
3
Pricing and embedded fees
Structured Equity Products sold to retail investors provide an
example of the importance of embedded fees
Characteristics of some SEPs;
• One year to maturity
• Have some equity exposure, but are less risky than the
stock
• Embedded fee of up to 8%
8% embedded fee and 1-year maturity imply that the expected
return is 8% less than the expected return on a portfolio of
stock and bonds of the same risk, i.e. the “alpha” is -8%.
A low-risk product with an “alpha” of -8% has an expected
return less than the risk-free rate of interest
Based on Henderson, Brian J. and Neil D. Pearson, 2011, The Dark Side of
Financial Innovation, Journal of Financial Economics 100, No. 2, pp. 227-247.
4
Relevance for fund directors
• You are probably thinking that this doesn’t have any
relevance to you… after all, mutual fund managers are
much smarter and more sophisticated than retail investors
• But I remind you that tranches of subprime CDO’s were
purchased by professional fixed-income money managers,
some of whom were supported by teams of “quants”
• Many professional money managers invest in products that
have significant embedded fees
• For example, exotic derivatives, structured notes and CDO
tranches typically have significant embedded fees
5
Liquid, two-way markets are safe places to invest
• It is difficult to make a big mistake investing in securities
traded in liquid, two-way markets
• You can take comfort in the fact that many other investors,
including sophisticated investors, are buying and selling on
the same day
• If you randomly select a diversified portfolio of large-cap
U.S. stocks, you will end up with a portfolio that is highly
correlated with the S&P 500 index
• Your performance will not differ much from that of the
index (setting aside your expense ratio)
• On the flip side, superior performance is also very difficult
to achieve
6
Illiquid, one-way markets are dangerous
• It is easy to go wrong investing in securities traded in a
illiquid, one-way market
• Usually you are buying, and a sophisticated dealer is
selling
• You have to be good enough to overcome the embedded
fees and the dealer’s inherent informational advantage
• If you randomly select a diversified portfolio of structured
notes, you will underperform relevant benchmarks
• Manager skill, or lack thereof, becomes much more
important
7
Another reason to be concerned about portfolio
managers who trade illiquid securities
Distribution of monthly hedge fund returns 1994–2005
5%
4%
3%
2%
1%
25
20
15
10
5
0
-5
-10
-15
-20
-25
+50
+45
+40
+35
+30
+25
+20
+15
+10
+5
-5
-10
-15
-20
-25
-30
-35
-40
-45
-50
0%
From Bollen, N. and V. Pool, 2009, Do Hedge Fund Managers Misreport
Returns? Evidence from the Pooled Distributions, Journal of Finance 64, No.
5, 2257-2288
Figure is based on a total of 215,930 monthly returns
8
25
20
15
10
5
0
-5
-10
-15
-20
-25
0.0912
0.0855
0.0798
0.0741
0.0684
0.0627
0.0570
0.0513
0.0456
0.0399
0.0342
4%
0.0285
0.0228
0.0171
0.0114
0.0057
0.0000
-0.0057
-0.0114
-0.0171
-0.0228
-0.0285
-0.0342
-0.0399
-0.0456
-0.0513
-0.0570
-0.0627
-0.0684
-0.0741
-0.0798
-0.0855
-0.0912
Distribution of monthly hedge fund returns 1994–2005
5%
Histogram of returns
3%
2%
1%
0%
Difference between
reported return and
prediction from a
smooth distribution
9
Why is there a discontinuity in the distribution?
The discontinuity:
• Does not appear in distribution of returns from audit
months … but does appear in non-audit months
• Does not appear in the returns of equity-market neutral
funds or CTA’s … but does appear in returns of funds that
invest in illiquid securities
• Is much more prevalent in the returns of funds for which
there is other evidence suggesting smoothed returns
• Is more prevalent in the returns of defunct funds than funds
the existed as of the end of the sample period
10
Audit versus non-audit months
5
4
3
2
1
0
-1
-2
-3
-4
-5
5
4
3
2
1
0
-1
-2
-3
-4
-5
11
+25
+20
+15
+25
+10
0%
+5
0%
-5
2%
-10
2%
-25
4%
+20
4%
+15
6%
+10
6%
+5
8%
-5
8%
-10
10%
-15
10%
-20
12%
-25
12%
-15
Non-audit Months
-20
Audit Months
Discontinuity by strategy
0%
5
4
3
2
1
0
-1
-2
-3
-4
-5
+25
5
4
3
2
1
0
-1
-2
-3
-4
-5
12
+25
0%
+20
1%
+15
1%
+10
2%
+5
2%
-5
3%
-10
3%
-25
4%
+20
4%
+15
5%
+10
5%
+5
6%
-5
6%
-10
7%
-15
7%
-20
8%
-25
8%
-15
Distressed Securities
-20
Equity Market Neutral
10
8
6
4
2
0
-2
-4
-6
-8
-10
-0.0408
-0.0374
-0.0340
-0.0306
-0.0272
-0.0238
-0.0204
-0.0170
-0.0136
-0.0102
-0.0068
-0.0034
0.0000
0.0034
0.0068
0.0102
0.0136
0.0170
0.0204
0.0238
0.0272
0.0306
0.0340
0.0374
0.0408
-0.0960
-0.0880
-0.0800
-0.0720
-0.0640
-0.0560
-0.0480
-0.0400
-0.0320
-0.0240
-0.0160
-0.0080
0.0000
0.0080
0.0160
0.0240
0.0320
0.0400
0.0480
0.0560
0.0640
0.0720
0.0800
0.0880
0.0960
Smoothing profiles
Low Smoothing
High Smoothing
7%
7%
6%
6%
5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0%
0%
10
8
6
4
2
0
-2
-4
-6
-8
-10
13
20
16
12
8
4
0
-4
-8
-12
-16
-20
-0.0504
-0.0462
-0.0420
-0.0378
-0.0336
-0.0294
-0.0252
-0.0210
-0.0168
-0.0126
-0.0084
-0.0042
0.0000
0.0042
0.0084
0.0126
0.0168
0.0210
0.0252
0.0294
0.0336
0.0378
0.0420
0.0462
0.0504
-0.0624
-0.0572
-0.0520
-0.0468
-0.0416
-0.0364
-0.0312
-0.0260
-0.0208
-0.0156
-0.0104
-0.0052
0.0000
0.0052
0.0104
0.0156
0.0208
0.0260
0.0312
0.0364
0.0416
0.0468
0.0520
0.0572
0.0624
Defunct vs. live funds
Defunct Funds
Live Funds
6%
6%
5%
5%
4%
4%
3%
3%
2%
2%
1%
1%
0%
0%
20
16
12
8
4
0
-4
-8
-12
-16
-20
14
From the Financial Times 6/28/07
Does it all add up?
"It is very easy for hedge funds to shop around to find valuations that suit them
best and then book their assets at that," says one banker who advises hedge
funds. "Going back to the bank that sold you a CDO and asking for a price is
rarely likely to produce an accurate picture.“
15
How prevalent is the phenomenon?
• In the overall sample, about 1% of returns are affected
• If you see a monthly return of 0%, the probability it was
misreported is about 25%
• For funds that specialize in distressed securities, about 2%
of returns are affected
• If you see a monthly return of 0%, the probability it was
misreported is about 33%
Misreporting monthly returns to be 0% rather than slightly
below 0% is not the only form of misreporting
Copyright © 2011 by Neil D.
Pearson. All rights reserved.
Other implications of misreporting of returns
Misreporting also:
• creates serial correlations in returns; and
• “smooths” returns
Unless one adjusts for it, the smoothing of returns results in
underestimates of risk statistics (volatility, “beta,” and
factor loadings), and thus overestimates risk-adjusted
performance or “alpha”
Copyright © 2011 by Neil D.
Pearson. All rights reserved.
Should You Worry About This?
• The problem is prevalent in hedge funds that invest in illiquid
securities
• Is it due to the fact that hedge fund managers are particularly
prone to manipulate reported returns?
• Or is it due to the fact that portfolios of illiquid securities
provide the temptation?
18
Can You Detect Hedge Fund Misreporting?
Bollen and Pool (2010) argue that the following
characteristics of hedge funds returns are suspicious:
• a discontinuity in the distribution of hedge fund returns,
• low correlation between hedge fund returns and the returns
of systematic risk factors,
• serial correlation in hedge fund returns,
• conditional serial correlation in hedge fund returns, and
• a family of six data quality indicators (e.g. the percentage
of negative returns, the percentage of repeat returns, and the
number of returns exactly equal to zero).
Copyright © 2011 by Neil D.
Pearson. All rights reserved.