Every client has a goal when investing with a manager. For an institutional client, say a pension fund, the goal could be to meet an expected rate of return so that the pension will be able to make all payments to retirees without drawing from a separate budget. For the individual client, the goal could be to pay for a new house or save for retirement. The asset manager’s job is understand and help meet clients goals. Asset managers keep clients regularly informed with performance and valuation data. Working together, the asset manager and the client can then discuss and make changes to client portfolios to ensure the client continues to meet goals.

Valuation Can be a Tricky Business

That’s why valuation is such an important part of being an asset manager. Imagine if the asset manager presented a portfolio to the client that is not accurate. For example, the manager owns a real estate holding in the client portfolio and decides to value the real estate haphazardly by randomly choosing a number based on a hunch or by using comparable sales data from a past real estate boom. What is the impact on the client when the real estate holding turns out to be worth drastically less? The client suddenly has to determine how this change impacts his goal.

Unique and Hard-to-Value Assets

At the same time, clients need to be aware that there are nuances with valuation and performance that may affect the level of accuracy. Specifically, some assets, like cash, securities, commodities or bonds, have values that are known at any given point in time because the market determines their worth. The value of other assets, however, may not be as readily available or as precise. These are known as unique and hard-to-value assets. A good example of a difficult-to-value asset is an illiquid asset like real estate. According to the Office of the Comptroller of the Currency, a part of the U.S. Department of the Treasury, “Unique assets include real estate, closely held businesses, mineral interests, loans and notes, life insurance, tangible assets, and collectibles.”

Despite the lack of a market-setting mechanism or trading data for some assets, the asset manager must engage in a valuation process that is reasonable, consistent and has a sound basis. In other words, the valuation process must have an underlying rationale that is in line with widely accepted valuation methods and techniques. The ambiguity associated with valuing certain assets, together with the high level of importance placed on determining a near accurate valuation, means that both clients and asset managers should understand and agree on how these metrics are calculated and presented. Because although there are accounting rules governing how to calculate some assets like these, they are not always black and white and the asset manager has some wiggle room for determining the paper value of the asset.  

Standard Performance and Valuation Guidelines

Asset managers have devised various procedures and commissioned numerous technology solutions for determining valuation and calculating performance. The CFA Institute, a professional organization for investment professionals, released guidelines to direct asset managers toward well-founded performance and valuation procedures. The two guidelines, discussed below, are designed to ensure the client is given full disclosure and the calculation methodologies are fair and accurate.

1 . The manager needs to provide performance that is accurate and timely. 

First and foremost, asset managers must provide accurate performance, taking care to make sure they are not misrepresenting performance in any way. For example, the manager must not misstate historical performance to make it more impressive or provide performance data for a portfolio managed by an entirely different team. Asset managers, in addition, cannot provide partial historical data that show only their positive performance. They need to provide the track record in its entirety. Lastly, if data being portrayed is not actual performance but hypothetical or back-tested performance, managers should report it as such. The purpose of all these guidelines around historical data is simple. Prospective clients make decisions on which asset manager to use based on historical returns. If the historical data presented is not truly representative of the the team, process or firm, then the client will make a decision based on false information.

Many managers have turned to performance reporting that uses widely adopted standards, such as  Global Investment Performance Standards (GIPS). This standard provides clients with comfort around the methodology used to calculate performance, assuring clients the information is fair and complete. The reliability of GIPS performance data leads clients to feel confident that the information is trustworthy. (For more see A Guide To Global Investment Performance Standards.)

2 . Managers should follow generally accepted valuation methods. 

When there is a fair market price to value holdings, managers should adopt the market setting price methodology. But when there is no comparable market for a security, then managers should attempt to find an independent, third-party market quote.

One reason that an independent third party should maintain the valuation is to avoid a conflict of interest. In some cases, asset managers are paid based on the level of assets or returns that they generate. At the end of a period, the current holdings need to have an ending value from which to calculate a holding period return. That return determines the asset manager’s fees. If the asset manager is responsible for determining the value of an illiquid asset or holding that has no comparable market practicing, then that manager may be tempted to overvalue the asset in order to receive a higher fee. To avoid this conflict of interest, managers should allow independent managers or third parties to value the holdings.

Asset managers are encouraged to use widely accepted valuation methods to value portfolio holdings. Managers should consistently apply these methods. Accounting guidelines and professional standards recommended that portfolio holdings should be first valued based on market prices for identical assets. If there are no identical assets, then a similar asset can be used as a base price and adjusted for differences. It is important to note that these prices need to come from liquid markets. Illiquid market prices may not be reliable or accurate because they may not be current or representative of a normal, efficient transaction. If neither an identical asset or a similar asset is available for valuation, then asset manager should turn to “widely-used and accepted models and valuation techniques that incorporate market-based assumptions should be used,” according to the standards put forth by the CFA Institute. At this point, the manager should turn the valuation over to an independent third party.

The third-party valuation should include a regular review of the methods and assumptions used.

The Bottom Line

Valuation and performance is critical to all clients. Clients need to feel confident that the values in their portfolios are up-to-date and as close to the actual market value as possible. Without a high level of conviction that valuations are accurate, it is impossible for asset managers and clients to meet financial goals.