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Digging in to alternative investments
Matt Judge, 03/16/2016
Director, Strategic Relationship Manager
If you plan to incorporate alternative investments into your clients’ portfolios, it’s important to explore the details.
As a Registered Investment Advisor (RIA), you know that all investing has its risks. For some advisors, alternative investments have become their go-to plan for helping to mitigate risk through the seeking of noncorrelation or use of hedging strategy. If you plan to incorporate alternative investments into your clients’ portfolios, it’s important to explore the details.
Fortunately, the SEC Office of Compliance Inspections and Examinations recently released a Risk Alert to help you carefully weigh your due diligence options. In reading this alert, it became clear that when attempting to choose alternative investments, due diligence comes in two primary forms.
Leveraging third-party transparency reports
To help get a holistic, unbiased view of the performance and holding of alternative investments, it’s worthwhile to receive periodic “transparency reports” from an independent third-party source. These reports often include:
|•||The net value of the assets|
|•||The percentages of investments|
|•||Which custodians hold the investments|
|•||What percentage of investments are priced by a third-party administrator|
|•||Which assets and liabilities are measured and/or categorized by the fair-value hierarchy|
Seeking transparency directly from asset managers
You may find that many asset managers are hesitant to provide additional transparency that could undermine their strategies. However, if you’re able to find an asset manager who is comfortable sharing more detailed information about alternative investments, you can work more effectively to assess risk by:
|•||Fine-tuning your analyses of market sector exposures|
|•||Identifying position concentrations across the entire portfolio|
|•||Identifying positions that seem inconsistent with the manager’s stated investment strategies|
Managing assets within separate accounts
While many managers of alternative investments may prefer to use a pooled investment structure to minimize expenses or increase operational efficiency, you should attempt to negotiate the use of a separate account for your clients’ assets. Using a separate account may constrain the manager’s decision making over the assets and reduce his or her ability to charge unauthorized fees. Additionally, holding the assets in a separate account can help you monitor the investment portfolio’s liquidity and valuation.
Asset managers typically work with a number of third-party service providers, such as administrators, custodians, and auditors. It’s not enough to assume that your manager has performed their due diligence to vet these vendors. You should also perform your own verification to confirm that there is a relationship between the asset manager and his or her stated vendors. If the asset manager uses a vendor that isn’t familiar to you or your firm, be sure to perform additional due diligence to ensure he or she is the right vendor to handle your clients’ investments.
Reviewing the regulatory paper trail
To help identify an asset manager’s past regulatory issues or potential weaknesses, advisors should research the backgrounds of the asset managers (who are also registered investment advisers) and their associated brokerage firms and individual adviser and broker-dealer representatives. You should review regulatory filings and request that the manager provide any examination-related letters from the U.S. Securities and Exchange Commission (SEC).
Emphasizing operational due diligence
Moving forward, one way to help verify that each and every alternative investment in your clients’ portfolios is properly vetted is to establish a dedicated team that specializes in operational due diligence. The members of this team can work to review each alternative investment manager and have the power to veto any candidates that don’t meet your firm’s standards.
In addition to building transparency and engaging in advanced verification, there are a number of other ways you can vet alternative investments. For more suggestions, explore the SEC Risk Alert.
Content provided is for educational purposes only and is not intended to be advice for any firm.
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