The boom in alternative investment growth and a spike in investor mistrust seem headed for a collision course—with advisors stuck in the middle.
As the alt juggernaut rolls along, according to CaseyQuirk’s Retooling U.S. Intermediary Sales survey published last year, advisors are expected to increase their alt allocations by 23 percent between 2014 and 2017. In fact, alts are expected to outpace every other asset class except for international equities, which are expected to grow at a similar rate.
Meanwhile, the 2014 annual report from the Financial Industry Regulatory Authority (Finra) raised concerns that advisors are forgetting their obligation to put client needs first. Finra zeroed in on problems with alts in its 2015 Regulatory and Examinations Priorities Letter. Noting that “there is no standard definition of alternative mutual funds,” Finra determined that too few customers understand what the products are, while too many advisors don’t understand how they work. Finra pointed out that some firms are “not even reviewing alt funds through their new-product review process.”
“With alts under greater scrutiny than ever, investment professionals must be sensitive to the heightened concerns surrounding them,” said Jeffrey Kelley, senior vice president of Equity Institutional, a passive custodian specializing in the custody of alternative investments based in Westlake, Ohio. Equity Institutional does not offer investment advice or sponsor products.
Alt Alert From The SEC
The Securities and Exchange Commission has piled on, too. Its Office of Compliance Inspections and Examinations (OCIE) recently issued a risk alert on Investment Adviser Due Diligence Processes for Selecting Alternative Investments that details procedures for advisors to improve screening, selecting and monitoring of alts before recommending them.
In its descriptions of current industry trends and practices, the OCIE alert notes that financial advisors have generally met their oversight obligations by:
• Requesting more information and data directly from alternative asset managers.
• Turning increasingly to third parties to validate and augment the investment information they’ve been receiving.
• Applying additional quantitative analysis and risk assessments to both managers and specific investments.
Still, according to the OCIE alert, “certain deficiencies” were evident among a number of advisory firms:
• The omission of alternative investment due diligence policies from their annual reviews, even though the portion of client assets allocated to alts has been growing steadily in recent years.
• Potentially misleading information in marketing materials about the scope and depth of oversight conducted when qualifying investment recommendations.
• Practices in qualifying alts that differ from what was described in the advisors’ disclosures to clients.
In addition to highlighting the need to act in the client’s best interest, the alert notes that advisors have an obligation to determine whether alternative investments meet clients’ investment objectives and are “consistent with the investment principles and strategies that were disclosed by the manager to the adviser.”
This intense regulatory focus on alternatives comes at a time when other government entities, from the White House to Congress, are reminding advisors and asset managers to behave better. Hedge fund assets have more than doubled since hedge fund manager Bernie Madoff’s arrest seven years ago for running a $50 billion Ponzi scheme, but some continue to skirt the law. Without guard rails for alt accountability, advisors and their clients can still be vulnerable to a con job.
Stuck between the roaring demand for alts and millions of cash-heavy, aging investors, what can financial advisors do to act in their clients’ best interest, while also managing their bottom line?
Checklist For Improving Oversight For Alt Selections
“Highlights from the OCIE alert offer a starting point for investment professionals who are trying to stay on the right side of this issue,” Kelley said, “but advisors may wish to go even further in anticipation of new, stronger regulations.”
Given the turbulent economic landscape and regulatory environment, the burden on professionals to stay up to date on their burgeoning oversight obligations in the alternative universe may seem daunting.
Conversely, the need to make the effort is greater than ever. According to McKinsey & Company, investments in alts have been growing at a five-year rate of more than seven times that of traditional asset classes. Today, according to a survey by, 78 percent of financial advisors believe that “alternatives are a critical and important part of asset allocation.”
While by no means comprehensive, Kelley provided the following steps for fiduciary-minded advisors to consider before making alternative investment recommendations: 
1. Understand Your Alts. Given the variety and complexity of alts, it may be better to gain in-depth knowledge in a single area—or to have trusted experts on hand for specific asset classes —than to try to learn about every alt asset class.
Real assets, for example, are popular alt investments, because they can complement stock and bond holdings. But real assets are complex and are regulated at the federal, state and municipal level. A potential review before investing in real estate may begin with a review of historical financial statements, pro forma financials, assumptions and budgets. A market assessment and economic impact studies will be needed. Other steps should include a comparative evaluation of original underwriting with your financial analysis, a review of discounted cash flow models and a review of major tenants and leases, including a credit analysis and abstraction. 
Third-party work must also be coordinated and managed, including a broker’s opinion of values, property condition reports, environmental reports, a legal and title review, and site visit reports. Additional review could include stratification and mapping of assets by geography, performance, collateral type and size, as well as collateral site inspections, a downside scenario analysis and a loan recovery analysis.
A similar list of criteria could be compiled for precious metals, private equity and other alt asset classes.
2. Know Who Is Managing The Money. It’s not enough to skim the surface. Dig deep. Many advisors are now employing the services of third-party firms to conduct comprehensive background checks on managers and other personnel. These efforts often include investigation of employment history, legal and regulatory matters, news sources and independent reference checks.
3. Check The Stats. Probably nowhere has advisor psychology changed more than in the area of oversight that pertains to investment results. The OCIE alert notes that advisors are increasingly employing analytical tools, such as evaluation of bias ratio, serial correlation and “skewness” of return distribution, to uncover aberrations and identify managers who have falsified or manipulated returns.
Bias ratio, for example, can detect valuation bias or deliberate price manipulation of portfolio assets even when actual holdings are not disclosed. It measures abnormalities in the distribution of returns that indicate the presence of bias in subjective pricing. Serial correlations are often found in repeating patterns when the current level of a variable affects its future level. Skewness measures the degree of asymmetry of a distribution around its mean.
4. Amp Up Operational Oversight. The OICE alert notes that some advisors have substantially increased their efforts and built dedicated operational teams whose purpose is to veto any alternative investment manager candidate who does not satisfy the team’s review. The team’s process may include a review of legal documents, with special attention being paid to redemption terms and the liquidity of the portfolio. The process may also include on-site visits to managers and a review of the alternative investment’s audited financial statements. 
5. Verify Independence Of Service Providers. Advisors increasingly want to know who the third-party service providers are in the loop with the alternative investment manager they are considering. The SEC staff noted that many advisors are independently verifying relationships with administrators, custodians, auditors and others. The OCIE alert noted that some advisors would not make a new investment in a private alternative investment fund if it did not have an independent third-party administrator. This way firms appeared to gain greater confidence in the reliability of net asset value calculations, fund accounting, trade reconciliation and shareholder activity.
6. Seek Greater Transparency. According to the OCIE alert, advisors are using third party aggregators to supplement analyses and validate information in greater numbers than ever. Aggregators generally receive detailed portfolio-level information from private alternative investment funds and transmit it to advisors. This aggregated information is designed to help advisors make broad risk assessments about investments, while still protecting the alt manager’s proprietary information regarding specific positions. 
Aggregators are a compromise meant to address the conflict between advisors, who want as much information as possible, and alternative investment managers, who may be looking to keep proprietary methodologies under wraps by restricting portfolio details.
Another way to increase transparency is through the use of separately managed accounts, instead of pooling assets. Advisors who recommended that their clients’ assets be managed within a separate account told the OCIE, in many cases, that they could provide more transparency and greater control over how the assets were invested, “because the manager’s control over the assets is limited to trading authority.” They also concluded that separate accounts are a better structure for monitoring liquidity and valuation, while keeping a close watch on unauthorized fees or expenses.
“Consistent oversight of the activities of alternative investment managers, their results and their service providers can increase the potential for a better client experience,” said Kelley. “Regardless of where advisors look for information on their oversight obligations in the alternatives area, they may want to ensure that their firms develop clearer policies sooner rather than later.”
With pressure on financial advisors continuing to mount, there may be no alternative to putting their clients’ interests first—and keeping them there.
John Drachman, a Series 7 Registered Representative with 20 years of experience developing marketing communications initiatives for RIAs, is the founder of AlphaSegment. He can be reached at