Financial planners tend to enjoy (or at least prefer) spending time with their clients, helping detangle and re-organize many facets of their finances, and encouraging them to live enriched and fulfilling lives, to borrow oft-cited adjectives from their corporate missions. Running a holistic practice and maintaining expertise on a broad swath of topics from insurance to taxes can leave little room on their calendars for investment due diligence, yet many advisors lose sleep over whether or not they are fulfilling their fiduciary duty in this aspect of their practice.
To recommend or not to recommend?
Combining this with a desire to differentiate themselves from local competition and provide comprehensive services including investment management can leave them in a quandary: should they go the “safe” route and recommend entirely from a short list of well-regarded, low-cost ’40-Act funds according to a risk-based allocation to stocks, bonds, and cash? Or should they go the extra mile(s) and explore non-traditional options to enhance the risk-adjusted return of a portfolio, or to offer customized solutions to unique situations and sophisticated clients?
Steps for vetting alternative investments
Often, the planner choosing the latter finds him- or herself struggling to find the time or expertise required to evaluate the legal, financial, and reputational standing of boutique managers in asset classes that behave in less-transparent and less-understood ways than traditional markets. For planners who recognize that trying to be a jack-of-all-trades is a potential path to disaster, there is a way. Below are a number of steps a fiduciary advisor can take to set him- or herself apart by incorporating alternative investments:
- Make sure it enhances the portfolio characteristics. Thorough evaluation of expected risk, return, and covariance with other assets is an absolute must. To put it one way, you must determine whether the diversification benefits are worth it if it’s going to reduce your expected return. Liquidity is another factor requiring consideration with alternatives.
- Make sure it’s not just a sales pitch. There are a lot of experts in a lot of fields who have made or claim to know how to make money at it. That doesn’t mean he or she will continue to do so, or that the manager didn’t just get lucky in the past. Detailed statistical and economic analysis, and fundamental research of the past, present, and expected future environment can help see through the noise and slick-looking slide decks.
(Full disclosure: East Bay Financial Services works to assist financial planners and advisory firms with these first two elements of the process. We work on our clients’ behalf to evaluate complementary investments to traditional asset classes and to find customized solutions for unique situations. We enjoy conversations with asset managers and figuring out whether or where a particular strategy fits in a portfolio.)
- Evaluate the regulatory history and legal status of the manager. While “once a thief, always a thief” may not be entirely true, it is important when entrusting other people’s money with someone else that you know their history (at a minimum!). Many alternatives are not regulated the way we are used to with registered funds, so you may have to open a lot of closet doors to find the skeletons.
- Know how to read the financials. For example, can you pore over the details of a prospective investment and determine whether a recent acquisition was really an acquisition as opposed to a business combination, or whether the acquisition expenses incurred should have been capitalized versus expensed and flow through the income statement?
Yeah, neither can we. East Bay does not employ lawyers or accountants, and we cannot possibly keep up with all the externalities and nuances unique to alternative investments. This is what led us to FactRight and other industry service providers to close the gaps that we can’t possibly fill.
Enlist the help of third parties
A prudent advisor would not invest in a mutual fund based solely on what its wholesaler says; at a minimum he or she might consult Morningstar or some other respected evaluation service. In the alternatives space, there might not be a service today with such a familiar name, but enlisting the help of third parties can certainly help in your own customized evaluations.
Mario Nardone, CFA, is president and founder of East Bay Financial Services, a Charleston, SC-based Registered Investment Advisor. East Bay provides outsourced investment strategy and research services for advisory firms around the world. Mario’s experience includes institutional consulting and ETF strategy as a manager at Vanguard and service as chief investment officer for a well-respected financial planning firm in the Charleston area. Mario is past president and current board member of CFA Society South Carolina and is a member of the Financial Planning Association. His approach to investments and the industry has been featured in Investment News, NAPFA Advisor Magazine, Charleston Regional Business Journal, The Post & Courier, and Northeast Pennsylvania Business Journal, and on public radio.
