Valuation is one of the most important functions performed by mutual funds. Federal securities laws require board approval of a fund’s valuation procedures and those of its service providers. Results of Deloitte’s annual Fair Valuation Pricing Survey indicate that fund directors continue to be involved in due diligence of pricing vendors. Meanwhile, advances in technology and evolving regulations are driving changes in valuation practices that directors are required to oversee. As the range of data types and analytics tools available from pricing vendors grows, some fund advisers are incorporating new data and dashboards into their reports to boards.
Recent Securities and Exchange Commission regulations addressing liquidity risk management, swing pricing, and reporting modernization have magnified the importance of vendor oversight. The topics and questions below are meant to assist fund boards in obtaining information useful for valuation oversight from pricing vendors with which their funds do business.
- Acquisition of market input data and pricing assumptions; filtering for outliers: By what means and through what channels does the pricing vendor collect market information and evaluated pricing inputs? By what means is incoming data analyzed and reviewed, if at all, before it gets used as inputs for their pricing models? (The same questions can be posed about any assumptive data used in the evaluation process.)
- Less-liquid securities: How does the vendor price securities in which transactions or executable quotes for the same security within a reasonably current time frame are frequently unavailable? What types of inputs does the vendor rely on most often to evaluate a security that rarely trades? How does the fund verify the data, assumptions and methodologies that its vendor(s) rely on to price those securities? When prices of comparable bonds are included in a valuation, does the vendor make available sufficient information to its clients to properly assess the methods used in selecting comparable bonds? Are objective gauges of security-specific liquidity incorporated into the pricing process?
- Market price volatility: How does the vendor monitor and account for market volatility in its evaluation process? What adjustments, if any, does the vendor make to its pricing assumptions, models, and methodologies, under volatile market conditions? What is the vendor’s track record during past episodes of major market volatility, in terms of both reliability of deliveries and quality of pricing?
- Evaluation quality controls: What checks are employed (both before and after release of end-of-day prices) that all appropriate factors relevant to the value of securities were considered (including all relevant market data available at time of evaluation), the pricing assumptions employed were reasonable, and that the vendor followed its own evaluation policies and procedures?
- Price challenge process: In collaboration with the fund adviser, review the pricing vendor’s challenge process and your funds’ historical results of challenges with that vendor. Review the adviser’s challenge activity reports, and confer with the adviser regarding the format and content of challenge reports they provide to the board.
- Vendor transparency and responsiveness to requests for pricing-related information: Historically (and relative to your fund’s other pricing vendors), how easy or how difficult has it been to obtain pricing inputs and other information that the adviser’s pricing department, the fund’s independent auditor, and the board itself require to independently verify the vendor’s prices and get comfortable with the vendor’s evaluation models, assumptions, policies and procedures? Beyond raw data, what value-added tools and assistance does the vendor provide to help place such data in context (i.e., generate quantitative and/or qualitative judgments of the degree to which their evaluations reflected current market conditions at time of evaluation)? Confer with the adviser and jointly formulate questions or requests to be posed to the pricing vendor to upgrade their transparency, if necessary.
- Applying fair value across time zones and local market holidays: What steps does the pricing vendor take to determine its evaluated prices as close as possible to the fund’s NAV calculation time? What resources does the vendor provide to adjust end-of-day evaluated prices for non-U.S. securities whose local markets close materially earlier than 4:00 p.m. ET? Does the adjustment process take account of only current FX rates, or are other inputs considered as well, such as an adjusted benchmark curve to capture activity in the Treasury futures and ETF markets; activity in comparable bonds that may occur after the local market close; and any direct market color that may be available from market outside of the security’s local market? Does the vendor provide current evaluations for days when a security’s local market has a scheduled closure (e.g., U.S. bonds on Columbus Day and Veterans Day) but other financial markets remain open?
- Sources and application of FX rate information: How and from whom does a fund obtain FX rates? How is FX rate information incorporated in the daily workflow—both the NAV process, and any other processes that may require a calculation of portfolio value on an end-of-day or intra-day basis? If the fund’s FX rate sources differ from those used by its pricing vendor, how are any source-dependent FX rate differences reconciled when computing NAV?
- Contingency planning: How is NAV calculated at times when a primary supplier of NAV inputs (such as a major trading venue, OMS, pricing vendor or fund administrator) is disrupted due to a technical glitch, cyberattack, physical event (major storm, earthquake, act of war) or other unexpected cause? What procedures does the pricing vendor have in place for contingencies when a third party that it relies on for pricing inputs is disrupted? What is the vendor’s track record of continuity of deliveries during past disruptive events (e.g., Hurricane Sandy, unscheduled shutdowns of trading venues)?
- Sub-advised funds: If the board oversees any sub-advised funds, which party is responsible for valuation oversight: the sub-adviser, the adviser, or is responsibility shared? What arrangements exist with the fund’s pricing vendors (along with custodians/fund administrators and any other critical parties in the information chain) to assure that the main adviser and the board can easily and regularly access data required to oversee portfolio valuations of sub-advised funds?
- Compliance management: Does your pricing vendor maintain a dedicated compliance and risk management program? Is the compliance program adequately staffed, resourced and independent from business activities? Is the compliance program structured to align with the fund board’s regulatory requirements related to oversight of its service providers, including conflicts of interest, record keeping, and testing? How do they identify, manage and escalate any business, operational or compliance related issues? How does the pricing vendor maintain surveillance of pricing and evaluation functions to ensure they can demonstrate consistent implementation of their methodologies?
Mutual fund boards are responsible for formulating, reviewing and approving fund’s valuation policies, and overseeing how funds implement those policies. When participating in due diligence reviews of current or prospective pricing vendors, board members may consider inquiring about (among other things): how the vendor obtains and filters input data for their evaluation process; evaluates less-liquid securities that may lack direct market color; accounts for market volatility; applies quality control checks in the evaluation process; responds to pricing challenges; makes pricing inputs and other information available to the fund; adjusts evaluated prices for time zone differences and local market holidays; sources and applies foreign exchange rates when pricing international securities; produces evaluations when a third party it relies on for pricing inputs is disrupted.
Members of boards that oversee sub-advised funds may also consider inquiring about the communication chain for evaluations and related information among the fund adviser, its sub-advisers, and critical third parties that may include pricing vendors and custodians or fund administrators.
Including these topics in their valuation oversight activities may assist board members in assessing their pricing vendors’ evaluation methods, procedures and business continuity planning, in context of relevant regulations.
Jon Jacobs is a senior fixed-income analyst for ICE Data Pricing & Reference Data, LLC. Evaluated pricing (including fixed-income evaluations), continuous evaluated pricing, end-of-day evaluations, and Fair Value Information Services related to securities are provided in the United States through ICE Data Pricing & Reference Data, LLC and internationally through ICE Data Services entities in Europe and Asia Pacific.
*This article is provided for informational purposes only and is subject to change without notice and does not constitute any form of warranty, representation, or undertaking.