5 Powerful Factors That Control Portfolio Valuations

Valuing a stand-alone portfolio holding is like guessing the position of a jumping-jack. Valuing the whole portfolio is more like predicting the position of a rider in the luge.

When tracking portfolio performance, valuations can deliver surprisingly precise measurements:

#1.  Each individual valuation error is less significant at the portfolio level.

#2.  Valuation errors are diversifiable, resulting in some portfolio holdings to be overvalued while others are undervalued (i.e. they cancel each other out).

#3.  Portfolio holdings were acquired as some point in time, which means there is always observable transactional data that can help normalize valuation framework and assumptions.

#4.  Many portfolios are constantly transacting in similar securities, which feeds observable market data.

#5.  Finally and most critically, portfolio valuations are more concerned with tracking changes in value, not the portfolio’s aggregate value. Valuation methods can be very precise in measuring changes when they are based on concrete financial and market data.

Portfolios of Debt Instruments

Let’s consider how the above factors apply to portfolios of debt instruments.

#1.  In a simplistic example, Loan A may be valued at $X while the borrower is not going to make any more payments. The valuation will be 100% wrong (if there are no recoveries), but at the portfolio level the error can be minimal.

#2.  While the Loan A value was overstated, many other loans were undervalued, as no defaults will actually occur. A recent snapshot of a Lending Club portfolio reveals that over 95% of all borrowers experienced credit score change since underwriting. Even if most credit scores drift, many improved credit scores will be compensated for those that decline.

While incorrect credit policy may still leave a substantial overhang of mispriced loans, the relative influence of mispricing at the portfolio level will be much less than that at an individual loan level.

#3.  A borrower sells an obligation to pay in exchange for cash he receives. The amount borrowed is the value of uncertain future payments. This price helps normalize valuation framework and key inputs, thus removing a substantial amount of subjectivity from future valuation updates.

Discount rate is one such subjective, imprecise, unobservable and yet critical factor in valuing debt. At origination, one can infer the discount rate, which can be carried forward with minimal adjustments. Without origination date analysis, guessing the right discount rate is extremely challenging.

#4.  Transactions are less prevalent in illiquid debt instruments. However, secondary markets exist for consumer loans, while many market participants buy and sell portfolios of loans. Each such transaction provides added opportunity to test and adjust valuation framework for contemporaneous market conditions.

#5.  Finally, most investors are concerned with return on their investment. The aggregate amount of the portfolio is not as relevant. To say that the portfolio returns 10% annually is more informative than to say that the portfolio is not worth $1 million.

A substantial amount of change will be explained by debt amortization and interest payments. The change in value of each $1 of outstanding principal will depend on changes in interest rates and outlook on credit risk. The direction and magnitude of valuation change is nearly certain in response to observed changes in interest rates. Likewise, valuation changes in response to new outlook on prepayments or defaults becomes more certain as vintages mature.

Portfolio Allocation Issues

Careful trending of portfolio values becomes even more informative as we consider that each specialized portfolio (e.g. consumer debt) is a part of broader investment policy (e.g. pension plan). A pension fund allocator needs to know how much to invest in each asset class relative to others. Each portfolio valuation has to trend to the same fundamental factors (such as interest rates) that other asset classes do. The lack of such trending would result in misallocating funds and ultimately ascribing more risk to the specialized portfolio strategy than warranted by its intrinsic economics.

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