Marking to market

“Marking to market” simply means updating the value of an asset or a portfolio of assets to reflect the latest available prices for said assets. This is easy to do when assets are publicly listed, highly liquid (easily bought and sold) and fungible (substitutable for one another). For example, FTSE 100 shares trade in huge quantities on a daily basis, so you can be very confident of the value of any shares in your portfolio simply by referring to the market price at any given moment.

It’s harder when transactions are less frequent, assets are not fungible, and the sales process is more involved, however. For example, you might have a rough idea of what your house is worth – and estate agents and surveyors will certainly give you an opinion on the matter – but the truth is that you don’t know for sure until you actually sell it. And on any given day, you can only be loosely confident of your estimate.

Why does any of this matter? One big problem in the 2008 financial crisis arose when banks were forced to write down the value of their holdings of sub-prime mortgage-backed bonds. This “mark to market” obligation meant banks’ liabilities outweighed their assets, blowing a hole in their balance sheets and leaving them effectively insolvent.

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At the other end of the scale, one reason why private equity returns look less volatile than those of public equity markets is because the underlying assets are revalued less frequently, and valuations are arguably more subjective. Private equity firms say this is reflective of the fact that these investments are meant to be long term and that it protects investors from needless and artificial volatility.

Critics, such as Cliff Asness of asset manager AQR, argue that this amounts to “volatility laundering” and that investors in private equity are in fact often paying a premium for illiquidity, which they may be willing to do to avoid selling at bad times.