Valuation Process – How valid is the value?

The recent volatility in markets, across days and intra-day, got me thinking about how accurate is a fund unit price in this market. The calculation of a unit price is an estimate at a point in time however it is imperative to be as accurate as possible given the circumstances.

Fundamental to the calculation of a unit price is pricing the investments within a portfolio. Whilst this may seem like a simple exercise it requires a number of decisions and like much of the unit price process the result of these individual decisions can result in significant differences in the final outcome.

Listed equities would seem to be a very straightforward investment to value; just take the price at the end of each day. Which price? Do you use Bid, Offer or Last price, and what time should the price be taken? Market convention is to use Bid for long positions and Offer for short positions. Typically procedures would be in place for situations where:

• No Bid price exists
• No Offer price exists
• Tolerance checks for price movements from the prior day (typically 3%)
• Zero price checks
• Stale price checks where the price has not moved for a number of days (usually 3 days).

Additionally at least two pricing vendors should be used and comparisons made.

My experience is that all reputable organisations would have these controls in place as a minimum however there are a number of other controls that should be considered to maintain accuracy.

Thinly traded stocks. These may not be identified as part of the stale price check. Typically these stocks our outside the ASX200 and price movements can be sporadic. As there is a limited market for the stock what is the accurate price? Where there is a significant holding it is very unlikely that all the holding could be sold at the current bid.

Significant gap between Bid and Offer. If the Bid is significantly lower than the Offer using the Bid may be under-valuing the holding. If the gap continues there may be a case for applying a higher price than the Bid.

Penny stocks. If a share has a price of 1c then a move to 2c would be a 100% increase. Would the price movement exception identify if there was an actual error?

Delisted stocks. No market exists and it is common to apply a zero price until there is some certainly on any value that can be obtained.

Unlisted stocks. These should be independently valued or priced at cost. Is the valuer actually independent or do they have a vested interest in an inflated value? Should more than one valuer be used when there could be significant differences in value?

Significant holdings. Where holdings in a particular company exceed 5% is there a case for using a price lower than the end of day Bid given that any significant on market sale is likely to be at a lower price.

Periods of high volatility. Where there are wide gyrations across the market consideration needs to be given on whether pricing should be suspended. The assumptions that unit trusts work on is that unit issued based on the end of day price allow the cash to be invested next day at a similar price. In recent weeks we have seen situations where the market has opened 2-3% up or down from the previous day’s close (following the lead of US markets). This volatility is inequitable as existing investors are impacted as new investors cash cannot be invested close to the prices they were given. A solution raised in the past has been to calculate prices intra-day however this has proven to be impracticable. The remaining solution is to consider suspending pricing where holdings volatility exceeds certain parameters.

What triggers are in place to suspend the fund given large inflows or outflows? In volatile markets it is very unlikely that significant portions of a fund could be liquidated equivalent to the prices used for unit pricing purposes. For large funds or where there are significant holding in a particular stock consideration should be given to what the realisable value would be.

It is important that the pricing sources, timings and methodologies be reviewed on a regular basis to confirm that the controls are adequate. If the price movement tolerance is set at 3% and the market is fluctuating more than that each day then all stocks would be out of tolerance; is this causing real issues to be hidden?

Best practice is to institute a Pricing Committee whose responsibility is to own the Security Pricing and Asset Valuation methodology. Membership should consist of Risk & Compliance, Finance and Investment Management staff. The intention is to create a group that challenges and tests the existing process looking for potential weaknesses.