What to Consider Before Recommending Alternatives to Clients


By: Clive Slovin

It was another banner year for the equities markets in 2017, with anyone who had broad exposure to stocks likely very happy as we kick off a new year. While it’s always challenging to predict the future, the current landscape suggests that 2018 could once again be very favorable.

The story for alternative investments was a bit more mixed. While some vehicles within this class flourished, others didn’t do quite as well. At the same time, mid-cycle performance is hardly the best way to judge whether a specific alternative is on track to achieve its intended goal—or, for that matter, whether a client should be pleased or dissatisfied with the advisor who recommended it, which could have broader implications beyond just losing the relationship. It takes time.

This, in part, is why these offerings are typically reserved for accredited investors. But whether someone meets the technical definition of “accredited” is hardly the only consideration advisors should think about before placing a client in an alternative investment. Here are some key questions to consider:

  • Is the advisor confident that their firm has the proper due diligence procedures in place?An advisor, of course, has a responsibility to vet investments and ensure that they help balance out a client’s financial plan. They should also be able to count on their firm to conduct exhaustive due diligence on the front end, taking into account whether certain sponsors tend to underperform, charge high fees or suffer from other reputational issues. Remember, firms without a specialized expertise in this area may not have the same due diligence capabilities as others.
  • Does the investment complement the client’s broader financial plan? Advisors cannot offer products in a vacuum. In isolation, inverse correlation to equities or the possibility to realize outsized gains may be good enough reasons for clients to have alternatives in their portfolio. However, in the current landscape—where both good business sense and regulators require advisors to act in the best interest of their clients—there has to be clear financial planning rationale. If an advisor can’t have a linear conversation with a client about alternatives—“This is where you are in your current plan, this is where you may want to go and this is how this product will help get you there”—they shouldn’t have exposure to them.
  • Can the client, psychologically, handle being invested in alternatives? While some product companies have begun to introduce so-called “liquid alts,” advisors should remember that alternatives were never meant to be liquid. What’s more, because these investments offer access to asset classes that are beyond the reach of traditional vehicles, they have unusual market and industry risks that may be hard for some to understand fully. Clients therefore have to appreciate not only all the risks associated with a specific alternative, but also have to be comfortable taking on those risks. Those two ideas should not be conflated, and it could take an advisor tapping into their behavioral financial skills to help a client get to that point. Otherwise, they could be prone to making a rash decision at the first sign of trouble.
  • Can the client afford to take the risk? Understanding risks and being psychologically able to cope with them is one thing. Being able to afford to have a significant amount of capital tied up for long periods of time is another. Taking it a step further, though alternatives are not necessarily inherently risky, there is no question that they are riskier than most other investments, meaning it’s possible that a client could absorb a loss. Even many accredited investors have obligations and exposure in other areas which make them poor candidates for certain alternatives despite, in theory, being able to afford them.
  • Has the advisor been transparent about compensation? When critics of alternatives investments—or the financial services industry in general—talk about compensation, it’s rarely through the lens of what is reasonable. It’s almost always about the need to get rid of commissions and fees altogether. To them, an advisor is incidental to financial planning; they’re merely there to snatch a portion of an investor’s principal. Such arguments are obviously inane and demonstrate minimal grasp of what goes into helping someone prepare for retirement. Typically, advisors are compensated reasonably for providing these products when there is a need and should have no problem disclosing to clients how and what they are paid.

In a perfect world, investors could rely on the steady performance of the markets and generous interest rates to fund their retirement goals. The reality is much different. Equities will always wax and wane, and if the last decade is any indication, fixed income investments will continue to lag past performance. Therefore, if anything, alternatives will likely take on added importance moving forward, meaning advisors, if they haven’t already, need to start thinking about which clients may be good candidates for such investments.

As seen on WealthManagement.com

Empowering the Independent Financial Advisor – SFA