In one well publicized event, LPL Financial reached an agreement with the State of Massachusetts to pay $2.5 million for improper sales of private shares of real estate investment trusts. In discussing the matter, Massachusetts Secretary of the Commonwealth William F. Galvin said investors’ increasing desire for exotic investments is a big concern to regulators. The Financial Industry Regulatory Authority (FINRA), meanwhile, has had 10 staff members studying the proliferation of the products and sales practices during the past two years.
For advisors, alternative products can offer attractive commissions and be potentially appropriate for investors that are concerned about market declines, such as those following the subprime mortgage crisis and the burst of the dot.com bubble. Yet, advisors need to tread carefully when recommending alternative investments. The products can be complex, highly risky, and easily used inappropriately.
“Alternative investments,” of course, is a vague term. Even among broker-dealers, the classification of alternative investments can vary drastically. Generally speaking, the products can include highly regulated ‘40 Act mutual funds that manage risk by conducting short sales, portfolios that provide financing to start-up companies, programs that invest in complex derivatives, and real estate funds, to name just a few.
As with any product, it is crucial that advisors fully understand how an alternative investment product is managed and be able to communicate the risks associated with specific products to clients. Even among ’40 Act funds, considerable differences in risk can be found.
Some funds may seek to maintain diversified portfolios while others may focus on limited sectors. A fund that provides financing to start-up companies, meanwhile, may allocate assets to businesses that may fail because the companies have yet to establish steady revenues or may have inexperienced management teams. Funds that take considerable short positions present the risk that market gains will work against the value of short sales, thereby hurting performance.
Armed with an understanding of risks, advisors can then assess how different products may fit in with a client’s overall asset allocation. Importantly, advisors should also fully describe the nature of risk to their clients.
Advisors should note to their clients that the term “alternatives” is misleading. More specifically, few investment specialists would recommend using alternative investments as a substitute for traditional equities. Yet, in the aftermath of the subprime mortgage crisis, many investors have sold off traditional equity funds and have flocked to alternative investments.
The irony is that investors have done so to avoid the risk associated with equities, but in doing so have embraced an asset class that has an even higher level of risk. With that in mind, advisors should emphasize that alternative investments are best suited to provide diversification rather than serve as a core allocation within a portfolio. In doing so, advisors should point out that the products can present more risk than traditional equities and explain that investors who rode out the subprime mortgage crisis have recouped losses that occurred during the subsequent bear market.
By illustrating that traditional equities eventually recouped their losses and by showing the high levels of risk associated with many alternative investment products, advisors are likely to steer their clients away from the potentially costly mistake of allocating an excessive portion of their assets to non-traditional products. The practice can also help ensure that advisors recommend only suitable products for their clients.
