Financial Services Springing Forward The Eighth Annual Fair Value Pricing Survey

Transcription

1 Financial Services 2010 Springing Forward The Eighth Annual Fair Value Pricing Survey

2 Executive Summary and Key Trends and Findings The Fair Value Pricing Survey (the survey ) is our eighth survey and represents the current thinking related to valuation practices and industry policies and procedures used by asset managers. Valuation practices have evolved and matured over the last decade, yet investment companies were able to quickly understand the changing market conditions and make adjustments to the valuation process, enabling them to spring forward without losing investor confidence in the published daily NAVs per share. Investment companies also continue to make refinements as the range and complexity of investment types expand, board governance strengthens, and new investment valuation tools are introduced. The survey was designed with two goals in mind: 1. Provide information that will allow survey participants to understand how their practices, policies, and procedures compare to other asset managers in the industry; and 2. Identify emerging trends within the industry. The surveys we initially conducted focused on the valuation of foreign equities and interpretation and implementation of a process to handle a significant event. Our survey scope has expanded over the years, based on the requests of our survey participants, to mine benchmark information from hot topic areas that are not widely available, such as broker and vendor pricing, the price challenge process, utilization of models, and governance. Industry professionals representing 67 asset managers completed the survey. Those asset managers advise more than 3,000 mutual funds with assets under management (AUM) exceeding $2.2 trillion. The population of survey participants included those from fund complexes of varying sizes. Funds managed by these asset managers cover the full spectrum of investment types. Global Financial Storm Lessons Learned Asset managers experienced unprecedented challenges in valuing portfolio securities. Information is king and in some cases became scarce as third-party pricing vendors were challenged in their ability to provide evaluated prices. Spreads widened, liquidity did not exist, and regulators continued to debate the merits of longstanding valuation practices. In many cases, asset managers were left to seek pricing alternatives such as internal modeling, and also had to update valuation policies and procedures to address unforeseen events and a dynamic environment. As with any threshold event, asset managers performed a post mortem on the experiences gained and lessons learned from the credit crisis to further enhance and strengthen their valuation policies and procedures. Resources were dedicated to consider alternative valuation solutions such as models, expanding the valuation sources, shoring up the pricing challenge process and related documentation, as well Executive Summary and Key Trends and Findings 1

3 as tightening up communications between the Fund Board, Treasury, Internal Pricing Committee, Portfolio Management and Trading. Valuation Guidance The Financial Accounting Standards Board ( FASB ) issued valuation guidance last spring called FASB Staff Position Financial Accounting Standards (FAS) 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. The guidance, which is now codified in Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures, highlighted considerations for valuing assets and liabilities in the difficult market environment and clarified certain disclosure requirements. In early 2010, the FASB provided additional disclosure guidance in Accounting Standards Update No Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. The U.S. Securities & Exchange Commission ( SEC or the Commission ) did not issue any specific valuation guidance, but the SEC did post a bibliography of valuation guidance and other actions and released two valuation-related complaints/actions during the last year. The Investment Company Institute published an asset management compendium of SEC valuation guidance and other published valuation measurement and disclosure requirements. Fair Value Survey Results To participate or not to participate? This is the question those in governance need to understand with the renewed focus on navigating a business through tough times. However, Boards have not forgotten their fundamental responsibility to the shareholder, and they have found it very hard to accept business streamlining plans that increase operational and regulatory risks. There is no denying that risk management has found its way into the boardroom; it is clearly relevant today as firms try to protect their most valuable attribute - their reputation. Depending on the materiality and the level of risk involved, our survey results suggest that independent trustees may be consulted on a real-time basis when valuation decisions are reached. Clearly, one of the largest operational and regulatory risks relates to valuation. The industry is fully aware that valuation ineffectiveness cannot only lead to NAV errors and all that such errors bring with them, but also the increased potential for detrimental arbitrage activities, as exemplified in the market timing/late trading scandals, and investor discontent and panic, which the crisis involving registered and non-registered money market funds demonstrated. The industry has always known that valuation is more than just an accounting standard. One sign of the industry s focus has been its use of the price challenge process. Approximately 97 percent indicated that they have challenged the valuations by the primary pricing vendor. Almost 34 percent have been issuing price challenges daily. The rise of the price challenge process is not unusual given the volatility and uncertainty in the investment marketplace and the general strengthening of fund policies and procedures. Fund groups are more successfully teaming within their organizations, sometimes on a daily basis, to assess valuations provided by others using traditional and newly developed internal tools. The challenge process and questions asked have become more routine. Portfolio managers and traders have become more proactive in their assessment of the valuation process, and additional relevant information is being considered. However, extra care and controls need to be considered to ensure that changes to valuations are properly scrutinized. Models are being used by some asset managers, especially for structured securities. However, usage does not appear to be widespread, as many assets managers have focused on alternative valuation solutions. Executive Summary and Key Trends and Findings 2

4 We focused many questions in the survey on internal controls. Many common controls exist, although the survey noted differences in their application. Proactive and robust controls are important in the ongoing compliance and assessment of accounting standards. Valuation continues to be an area of increased focus by regulators, such as the SEC and the Public Company Accounting Oversight Board (PCAOB), in their examinations. Overlying these demands are the potential complications resulting from a very volatile and increasingly global investment market that requires an ever increasing amount of financial data to perform a thorough analysis. As widening credit spreads narrow and the global markets stabilize, the challenges in the valuation process remain. As the results of the survey indicate, progress continues to be made by industry participants in addressing many demands in a difficult environment that requires appropriate valuation results be determined and disseminated on a daily basis. Specific trends and findings identified in the survey are highlighted in the next section. Key Trends and Findings Valuation Governance Considerations 58 percent of survey participants indicated that the Board of Trustees has created a separate Fair Valuation Committee. 48 percent of survey participants indicated that only non-interested trustees serve on the Board s Fair Valuation Committee. 39 percent indicated that the involvement is the same amongst interested and noninterested trustees. The majority of fund Boards in the survey review/ratify valuation decisions after they have been made. However, approximately 35 percent indicated that real-time involvement has occurred when more unique fair valuation decisions were made, especially when the valuation is significant or more than inconsequential. When Board members participate on a real-time basis, the majority of survey participants indicated that it is the non-interested Board members who participate (as opposed to interested Board members). The top three most common participants in the Board s Fair Valuation Committee are the chief compliance officer, the treasurer, and in-house counsel. Deloitte Point of View: Even when difficult valuation environments present themselves, Boards can still effectively meet their fiduciary responsibilities for oversight. Key elements of a successful governance process include: 1) asking detailed questions on matters such as the extent of due diligence on pricing sources, the adequacy and effectiveness of valuation controls, and the consistent application of the valuation policies and procedures; 2) evaluating responses; and 3) reviewing documentation that corroborates responses. Fair Valuation Policies and Procedures 84 percent of survey participants indicated that their respective fund groups had made changes to their fair valuation policies and procedures, mostly characterizing these as minimal or as moderate. The top two reasons for making the changes were to enhance language for the valuation of hard-to-value instruments and to add a pricing source. The most common internal controls over valuation that are performed daily include the comparison of daily prices to prior day prices, the review of stale pricing reports, use of secondary pricing source, and the use of Executive Summary and Key Trends and Findings 3

5 portfolio managers and traders to review the markets for any market- or-issuer-specific events that they believe may not be considered by the primary pricing provider. For equities, the most common thresholds used by survey participants to determine whether to investigate a fluctuation from a prior day were five percent or 10 percent. For fixed-income securities, thresholds between one to five percent were most common. Deloitte Point of View: Internal controls should be continually reassessed. With market conditions that have persisted over the last few years, new controls have emerged and should be documented and evaluated. Strong consideration should be placed on the competence and the objectivity of those performing the controls. Pricing Sources 73 percent of survey participants indicated that they feel that pricing services provide a more reliable valuation than brokers. 97 percent have indicated instances where they have challenged the valuations provided by the primary pricing vendor. Pricing services are generally approved annually by 66 percent of fund groups. Brokers are more likely to be approved on an as needed basis (54 percent). 67 percent of fund groups require that all broker prices be in writing. 34 percent of survey participants indicated that they issue price challenges to pricing vendors on a daily basis. When performing due diligence on pricing sources, 81 percents of survey respondents are asking their pricing services and brokers whether prices reflect the most recent transactions, an increase of 22 percent from the prior year s survey. Deloitte Point of View: Differences in how due diligence is carried out may exist depending on the pricing source involved, the types of investments valued, and how a fund group uses the prices. However, any differences that may exist should be understood and approved by those in oversight roles and other interested parties. Fund groups should have a process in place to determine whether sufficient evidence exists that suggests that a pricing source or methodology is no longer reliable. Specific Fair Value Considerations Foreign Equities 80 percent of asset managers said they use proxies to determine if closing exchange prices for foreign securities should be adjusted, representing a continued trend dating back to The S&P 500 and the Russell 1000 indices continue to be the two most frequently used proxies. 25 percent of survey participants indicated that they use more than one proxy. 31 percent of survey participants indicated that they use a zero trigger. Trigger percentages ranged from zero to 225 basis points. Executive Summary and Key Trends and Findings 4

6 Fixed-Income Securities 75 percent either use prices that incorporate information through 4 p.m. Eastern or have policies and procedures in place to update the valuation if significant events occur prior to 4 p.m. The Trade Reporting and Compliance Engine ( TRACE ) continues to be the largest source of market information, with 60 percent using it for comparative purposes, up from 36 percent in the prior year. Senior Bank Loans 84 percent of survey participants use either Loan Pricing Company or Markit Partners as their primary source in pricing senior banks. Seven percent were using brokers as their primary source. 59 percent of survey participants are performing additional procedures to corroborate the valuations they obtain from their vendors on senior bank loans. Small Cap/Micro Cap Equities 18 percent of survey participants are using the last available market price when a security price is stale, compared to 39 percent in the prior year. Most others automatically use a fair value process to estimate the fair value. 35 percent of survey participants indicated that they had discounted a publicly traded small cap/micro cap security after determining that the price was illiquid or stale. Counterparty Contracts/Commitments 79 percent of those responding to the question indicated that they use a pricing vendor as the primary source for interest rate swaps and credit default swaps. More than 90 percent of survey participants indicated that they had not used a credit valuation adjustment for counterparty risk when determining the price of a derivative contract. Illiquid Securities/Restricted Securities More than 65 percent of survey respondents have used a discount percentage in excess of five percent, and more than 40 percent have used a discount percentage of greater than or equal to 10 percent when discounting restricted securities without readily available prices. Deloitte Point of View: Vendor-based solutions for derivative contracts valuation have clearly evolved and have provided a welcome addition to the valuation process. Pricing service vendors provide many prices and tools for other investment types. As always, fund groups must nonetheless evaluate other factors that the vendor may not be considering in determining whether to use a price or whether an adjustment might be necessary. Foreign Currency Exchange Rates 78 percent of survey participants reported that they use foreign currency exchange rates at 4 p.m. Eastern. Deloitte Point of View: Using rates as of the close of the New York Stock Exchange (typically 4 p.m. Eastern) is clearly most common. In situations where these rates are not used, fund groups should have a mechanism to evaluate significant events that could occur between the time the rates are obtained and the time of day that the NAV is calculated. Executive Summary and Key Trends and Findings 5

7 Index Funds 67 percent of survey participants offering index funds indicated that they adjust closing exchange prices for foreign securities based on market indicators, and 31 percent of those survey participants offering passivelymanaged ETFs noted that they apply such procedures to them. 45 percent that value an index fund over a reporting period would disclose the fair valuation effect on performance. Deloitte Point of View: The evaluation and possible disclosure of the impact of any differences between the pricing methodology used by an index fund or ETF versus the benchmark clearly remains as a relevant consideration. ASC 820 More than 50 percent monitor the classifications under the fair value hierarchy (levels 1-3) on a quarterly basis. More than 90 percent of survey participants indicated that the impact on their valuation procedures of the adoption of FSP FAS 157-4, Determining Fair Value when the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions that are not Orderly," (now encompassed within ASC 820) was not significant. Deloitte Point of View: Actual transactional data is a relevant data point in determining the value of an investment and should not be ignored regardless of the type of investment. Tools for evaluating market activity, declines in trading volume, and the presence of an orderly market are clearly evolving, and automated solutions are especially important in making sure the valuation process is effective and efficient. We would be pleased to answer any questions you may have about our Survey, its results, or other fair value issues. Please don t hesitate to contact Cary Stier, U.S. practice leader, Asset Management Services, Deloitte LLP; Paul Kraft, partner and Fair Value Pricing Survey leader, Deloitte & Touche LLP; or any of the following partners: Contact Entities Telephone Cary Stier Deloitte LLP cstier@deloitte.com Paul Kraft Deloitte & Touche LLP pkraft@deloitte.com Rajan Chari Deloitte & Touche LLP rchari@deloitte.com Rob Fabio Deloitte & Touche LLP rfabio@deloitte.com Brian Gallagher Deloitte & Touche LLP bgallagher@deloitte.com Tom Kaylor Deloitte Financial Advisory Services LLP tkaylor@deloitte.com Elizabeth Krentzman Deloitte & Touche LLP ekrentzman@deloitte.com Alexey Surkov Deloitte & Touche LLP asurkov@deloitte.com Adam Weisman Deloitte Financial Advisory Services LLP aweisman@deloitte.com Executive Summary and Key Trends and Findings 6

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