Until relatively recently, alternative investments were the province of institutional and ultrahigh-net-worth individual investors. But today, alternatives have become increasingly mainstream, with a tremendous proliferation in options for mass affluent clients.
By and large, this has been a positive development for the financial services industry. Advisers can offer Main Street clients greater diversification by adding asset classes with low correlations to equity and bond markets. Tax advantages, performance enhancement, income strategies and access to previously untapped opportunities through alternative products also help advisers differentiate their level of sophistication and expertise from online and retail solutions.
And as “traditional” alternatives such as real estate investment trusts, hedge funds, oil and gas partnerships, business development companies, master limited partners and futures become increasingly popular, there is now more variety in the ways these investments can be structured, reflecting a wide range of investor needs and adviser business models. Some alternatives, for instance, are specifically suited for commission-based transactions, while others are appropriate for fee-based relationships.
There is no question that independent advisers presenting both fee- and commission-based services (so-called “hybrid” advisers) are particularly well-positioned to benefit from rising demand for alternatives. Relative to the rest of the industry, these advisers can offer clients greater flexibility among the products and strategies from which they can choose.
But there's also no question that evaluating whether specific alternative investments are a good fit for clients and which compensation structure might be most appropriate can be a complex process that carries responsibilities, obligations and risks.
There are four essential starting-point considerations for every adviser deciding which alternative investments they might offer, and under which compensation arrangement.
1. How liquid is the investment?
It's imperative to consider whether an alternative investment will accommodate the client's expected needs for liquidity. Liquidity of alternatives can range from daily, as in the case with open ended mutual funds, to multiyear illiquidity. In between, and on the rise, are “semi-liquid” products that offer a percentage of the units to be redeemed on a regular basis with frequency varying by product structure and sponsor.
Illiquidity can have material impact for investors as well for the adviser's compensation. For example, it may not be optimal to include alternatives that do not offer at least partial liquidity quarterly in fee-based accounts. Why? If an investment isn't really liquid for a year, then can the adviser rightly be considered by regulators to be actively managing the investment throughout the year? State regulators and various Securities and Exchange Commission jurisdictions may question the nature of “continuous and ongoing” advice on an asset that can't be sold. In some cases one time transaction-based compensation may be most appropriate. However, alternative product manufactures recognize investors' increased desire for a fee-based, same side of the table relationship and are striving to address the need for regular liquidity.
2. How frequently is the investment priced?
Perhaps the most important factor in determining the appropriate compensation structure is frequency of an investment's pricing. Fee-based advisers who are paid a percentage of assets under management throughout the year, often monthly or quarterly, should utilize products with similar pricing frequency. A product priced annually or less often might not accurately reflect the value of the adviser's services. This can potentially, and unfairly, reduce or artificially inflate adviser compensation. If the intent is that the adviser's compensation grows or declines as the value of the assets grows or declines, then an accurate depiction of the value of the assets is material to fee calculation. Therefore, simply stripping out a commission load does not constitute an investment suitable for an advisory, or fee-based, relationship.
3. What are the differences between applicable rules among specific regulatory jurisdictions?
Many advisers have widely dispersed clientele across several states. This can complicate sales practices, as states vary significantly in terms of their rules on liquidity, concentration limits for retail investors, net worth, and other factors that can affect portfolio construction. For example, in Ohio, a client must have liquid net worth of at least $250,000, or an annual gross income of at least $70,000 and a net worth of at least $70,000 in order to be considered an accredited investor and be eligible to purchase certain alternatives. But in Nebraska, that liquid net worth figure jumps to $350,000 or a net worth of $100,000 and an annual income of $70,000.
Moreover, concentration limits can also vary from state to state. Case in point, Ohio law states that no more than 10% of a client's liquid net worth can be invested in a single issuer or its affiliates. In the case of some of the largest sponsors of non-traded REITs, for example, one must be aware that some products are issued by subsidiaries that are not immediately apparent as having the same corporate parent. Inconsistencies across jurisdictions make it easy to unintentionally violate regulatory statutes, which can engender penalties and reputational risk.
4. Do you have sufficient ongoing due diligence capabilities?
Advisers need to have the knowledge and resources not only to perform initial due diligence on a potential alternative investment, but also to monitor the investment continually. The product and its management team should be reviewed regularly to ensure they consistently perform as expected. Many registered investment advisers or broker-dealers, even the largest firms, do not have sufficient depth of resources to adequately remain on top of these increasingly varied investments and to translate the information they receive to clients.
With these considerations in mind, hybrid advisers interested in expanding their work with alternative investments must remember that all activities should begin with education and end with documentation. Advisers introducing alternative investments should be constant students of the specific products they present as well as the space as a whole. Part of this effort involves actively leveraging the broker-dealer as well as key industry associations to help stay current with rules and regulations.
An even more important part of utilizing alternative investments involves educating the client. Although clients will generally trust in their adviser's recommendations, when it comes to alternatives it is wise to go the extra mile. They are not commonly discussed in mass media, are often misunderstood and, unfortunately, sometimes misrepresented by unscrupulous or sophomoric advisers. Sit down with clients and make sure they completely understand the investment's objectives, its features, and how it can be expected to perform. Then keep them updated on a regular basis.
Lastly, documentation is imperative. Document the due diligence you've performed, each time you update that research, when and how you educated the client and their acknowledgement of understanding. If there was a determination to make as to which compensation structure you used, document the rationale for choosing fee over commission for that particular product. Clear documentation ensures that you're following clear and repeatable processes in your use of alternatives.
In the complex world of alternatives, a repeatable and well-crafted due diligence and educational process that aligns the industry, the broker-dealer, the adviser and the end client is indispensable.
Michael C. Bryan is senior vice president of advisory services at Triad Advisors, Inc (www.triad-advisors.com). The firm is a wholly-owned subsidiary of Ladenburg Thalmann Financial Services (www.ladenburg.com).