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Due diligence critical as advisors look to alts

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WASHINGTON – Thorough due diligence must be a top priority in advisors' evaluation of alternative investments.

As more and more advisors, particularly those serving high-net-worth clients, consider alternatives, they need to ensure that they are conducting considerable due diligence before recommending that their clients invest in hedge funds, private equity funds or other non-traditional assets, a compliance expert warns.

Duane Thompson, senior policy analyst at the fiduciary training firm fi360, says that advisors -- regardless of the size of their practice -- must closely scrutinize the contents of an alternative fund and check and double check the claims that managers make in prospectuses and other marketing materials.

"It they're going to get into alts, there's no excuse for not doing due diligence, whether you're a large firm with $1 billion under management or $60 million," Thompson says.


It's no idle concern. The SEC has put advisors on notice that it plans to take a close look at alternative investments, naming that area as priority in its 2014 examination guidance, and then issuing a nine-page risk alert detailing the steps advisors can take to vet those funds before recommending them to clients.

The SEC identifies numerous warning signals that advisors should be on the lookout for when considering alternatives, including fund managers who are unwilling to provide basic information about their portfolio holdings, a drift in the manager's investment style over time, and the appearance of undisclosed conflicts of interest.

Some steps, such as running a background check on the fund's managers, might be considered common sense, but the SEC acknowledges that vetting an alternative fund isn't as easy as evaluating a more conventional asset like a mutual fund. Often managers of hedge funds, private equities and funds of funds work hard to keep a lid on the details of an investment strategy, an issue that the SEC says compels some advisors to hire third-party firms to check up on a fund and its management.


Thompson suggests that advisors develop a due diligence checklist for alternatives to include in their compliance manual, and determine whether a fund matches a client's investment profile and liquidity needs.

"It may not be as easy to sell shares in a hedge fund -- you need to look at the clients' investment time horizon and risk tolerance profile," he says. "As the advisor you need to make sure the client understands what they're getting into."

That a manager may choose to keep the detail of an alternative fund close to the vest should not disqualify an investment on its face, Thompson says. After all, some managers might be trying to protect trade secrets such as proprietary algorithms or complex investment methodologies.

But even if there's nothing nefarious about an alternative fund, it is incumbent on advisors under their fiduciary duty of care to ascertain the particulars of the investment.

"There's valid reasons for not having the same sort of transparency in their investment strategies as they might have in a mutual fund. But that said, you have to look under the hood," Thompson says. "I would be embarrassed to tell my clients I don't know what we're investing in."

Kenneth Corbin is a Financial Planning contributing writer in Washington.

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