Valuing Illiquid Assets

Transcription

1 Valuing Illiquid Assets By Chester Spatt* Board Oversight of Valuation Roundtable Center for Financial Policy, Smith School and Mutual Fund Directors Forum Reagan Center, Washington, D.C. November 21, 2013 *Carnegie Mellon University and former Chief Economist, U.S. SEC 1

2 Valuation and Investors Challenging when markets are illiquid Implicit options are subtle, but important Fairness Buyers vs. sellers Among funds, products Avoid stale prices, look-back options and dilution Costly to less sophisticated, uninformed investors Discourages desirable investors Fund valuations used for many purposes 2

3 Why is Board Oversight Important? Articulate a process, understand it, follow it and review it periodically Limits need for due diligence costs Crucial for common knowledge and expectations for investors, fund staff to be able to rely on it. Board: Arbitrator that looks beyond private incentives & disclosures of asset managers (Morgan Keegan) Crucial to satisfy fiduciary duties of board Boards scrutinized for ineffective oversight Monitor internal pricing; Approve and document overrides Even potential for fraud reliance on the Business Judgment Rule may not be a successful defense 3

4 History Mutual fund market timing scandals Complexes didn t follow or understand stated procedures Unsophisticated investors victims in many ways Implicit look-back options, valuation relevant Money market mutual funds and valuation Financial crisis and illiquidity Mortgage tranche valuation Transparency Trade allocation conflicts 4

5 Valuing a Property (House, Art)! Ultimate fragmented market but offers valuable lens Highly differentiated products, unlike many financial assets Last transaction? Adjusting for staleness Adjusting for trade direction Mid-quote? Suppose I raise my asking price? Information from other differentiated transactions? Imperfect substitutes; ratings insufficient too for financials Regression methods Appraisal Focus upon repeat sales? ( Repeat Sale Indices ) The most liquid properties returns have different returns 5

6 What s Different about Financial vs. Housing (Art) Markets? Quantities can influence valuation Houses, art objects are singular Competing sellers as well as buyers Allow greater opportunity and incentive to go short, more access to critical feedback (ideally) Trading more frequent Still, many instruments offer quite infrequent trading, so housing (art) provides a valuable lens 6

7 Valuation and Fund Liquidity Providing liquidity to both buyers & sellers Valuation is cast as size independent Mutual funds face a tough challenge as they offer daily liquidity without charge, even though market liquidity is limited! Tax externalities and capital gains lock-in Diverse horizon, yet same valuation by share class Hedge fund approach Less frequent valuation and liquidity provision ETFs immediacy, but priced via arbitrage 7

8 Modeling and Illiquidity Non-trading (absence of trading) Inaction on valuation? Stale prices (trading lags), trade infrequency Substitute prices (analogy: program trading ) Trading halts; Asset illiquidity and valuation Patient buyers vs. sellers Meaning of transaction prices Mid-quotes; Are spreads symmetric? Position size (important facet of illiquidity) Securities lending frictions, specialness Examples: RJR bonds ( ), Palm (2000) 8

9 Refining the Valuation Context Clarity about uses of valuation, objectives What adjustments seem suitable? To what extent is your expert focusing on valuation challenges? Subtle issues given the fund context (how valuations used) and illiquidity of some assets Independence of expertise Choice of model inputs Is pricing transparent, fragmented? TRACE; Fragmented trading and diverse dealers 9