RIAs: Hail to the Chief Valuation Officer?

Chief valuation officers could become just as important as chief compliance officers for registered investment fund managers. They also might discover that, like chief compliance officers, the position may carry personal risk of bruising regulatory penalties.

The emergence of this new C-class executive was predicted by panelists at a recent global fund valuation forum co-hosted in New York by data giant and evaluations provider Thomson Reuters and valuations consultancy Voltaire Advisors.

Jay Baris, partner with Morrison & Foerster in New York, says that the idea of a CVO might sound a bit far-fetched now. However, he would not be surprised if the US Securities and Exchange Commission were to require mutual fund boards to designate a CVO given the valuation-related legal liability of fund managers and the difficulty of pricing complex securities.

“The Investment Company Act of 1940 requires that fund directors determine in good faith the fair value of portfolio securities when there are no readily available market quotations,” he explains. “Fund directors cannot delegate this duty, but they can delegate the calculation of fair values in accordance with the methodologies they have approved.”

Ultimately, either the fund administrator or the fund accountant is responsible for the task. Valuations aren’t hard to do with exchange-traded instruments because they have a universally agreed-upon price, calculated mainly on end-of-day exchange prices. Not so for assets that are traded over-the-counter or ones that are traded too infrequently to establish a consensus. In these cases, financial firms are legally required under US and global fair-value accounting rules to turn to combinations of pricing models and inputs.

The more illiquid the asset, the more subjective the valuation because there is no comparable financial instrument to use. Depending on the size of a fund manager’s position in a hard-to-price asset, a pricing error could ultimately lead to an error in calculating net asset value. When that happens, the NAV may have to be readjusted and investors made whole. Valuation errors can also lead to incorrect investment and credit risk metrics.

Rules with Teeth

After late-day trading and market-timing scandals, the SEC in 1993 required investment fund managers to appoint dedicated chief compliance officers to ensure better operational oversight. The regulatory agency subsequently took fund boards to task for not properly pricing securities they own. In 2013 the SEC settled civil charges against eight former directors of Morgan Keegan’s fixed-income mutual funds for failing to correctly oversee the asset valuation process for securities backed by subprime mortgages, allowing portfolio managers to overvalue the assets. In 2014 the SEC reiterated its stance on the role of fund directors in the valuations process as part of its reform package for money market funds calling for floating rate net asset values.

The UK’s Financial Conduct Authority hasn’t focused on valuations per se, but has scolded fund managers for insufficient oversight of outsourcing contracts. Relying on an external party for valuations falls into that category. Europe’s Alternative Investment Managers Directive (AIFMD) requires alternative fund managers wanting to market their funds cross-border to establish written valuation policies, but makes no reference to board responsibilities. “The fund manager is given overall responsibility for valuation and the fund depositary has an oversight role,” explains Ian Blance, managing director of Voltaire Advisors in London. “Therefore, the US is more likely to create the CVO role first, with the requirement that the fund board make the appointment to have a handle on the whole valuation process.”

Designating a CVO would not only fall in line with the SEC’s attempt to ensure investment advisors not only set a sound valuations policy, but also develop dedicated liquidity risk management and derivatives risk management programs. Valuations go hand in hand with liquidity risk management. Fund managers must take the level of liquidity into account when pricing an asset. Likewise, pricing derivative contracts correctly is critical to an effective derivatives risk management program.

Many mutual fund complexes have created valuation committees, but they are only as good as their procedures. Hopefully, the fund management advisor will have set up a documented framework for valuing each non-exchange traded instrument, which includes relying on external help — a handful of third-party valuation firms. The policy needs to ensure that any price struck is independent and can be defended. Disputes or differences of opinion between internal and external valuations providers need to be resolved to the satisfaction of both sides.

Direct Report

So what’s wrong with the current committee-based system? “The board of directors of the fund might not always have clear and consistent communications with the valuation committee and might not understand the full process,” says Blance. The valuations committee might report to internal C-level executives, which in turn, report to the board. Given that the board has ultimate responsibility for any pricing errors, the convoluted reporting mechanism might go awry and subject the board to greater legal liability. Having a single individual reporting to the board is far more efficient and reliable.

 Without any SEC or other regulatory mandate for a CVO it’s hard to predict what his or her credentials should be, says Baris. It’s easier to list what might disqualify a potential candidate. The portfolio manager, trading desk manager or other investment desk professional can’t be selected, because of clear conflict of interest. Who is left?

Baris predicts that liquidity risk managers could be tapped, because of the importance of liquidity to valuing hard-to-price assets. Other valuation experts at fund management firms tell FinOps that quantitative experts with experience in specific asset classes would be an even better choice. “The valuations process is specific to each asset class; therefor, if a fund specializes in asset-backed, mortgage-backed or other instruments, the chief valuations officer should ideally have previous experience trading and pricing those particular instruments,” says a member of the valuations committee at a US fund management firm.

Ideally, according to Jayme Fagas, global head of valuations and transparency for Thomson Reuters in New York, the CVO should have a broad range of professional experience. “Former portfolio managers or traders, who have also done investment risk management analysis might be ideal, while data management would be helpful,” she says.”They would best understand the methodologies and inputs used in pricing fixed-income instruments as well as descriptive information such as interest curves, volatility and duration.” The reason: if there is a dispute among the valuations committee members, the CVO could become a tiebreaker.

Seven out of ten registered investment advisors contacted by FinOps agree that it’s only a matter of time before the SEC comes up with the necessary requirements for a dedicated valuation program. That in turn would likely spell the need for a supervisory CVO. “It’s an intriguing idea which deserves further thought,” says one compliance manager at an East Coast fund management shop.

However, all agree that a CVO isn’t going to be required for every firm. “Registered investment advisors handling vanilla equities and fixed-income instruments likely won’t need a CVO,” says one US investment fund compliance manager. “The SEC is more likely to demand a specific documented program and CVO for those investing in exotic non-exchange traded instruments.”

For fund managers that want to proactively appoint a CVO, Baris urges caution. Because there is no current rule requiring a CVO be tapped, there is no way to determine what the role would entail.

“Just how much personal liability the CVO would carry comes into question and it remains to be seen whether investment advisors would want to share legal responsibility with the board if a dedicated official were named,” says Fagas. “Individuals might shy away from the job, not wanting to take on liability.”