SEC Eyes Alt. Investment Practices

Financial advisers who propose alternative investments to their clients can expect increased, ongoing scrutiny from the Securities and Exchange Commission (SEC).

In a recent Risk Alert issued by the SEC’s Office of Compliance Inspections and Examinations, which is tasked with operating the SEC’s National Exam Program (NEP), regulators remind financial advisers that their fiduciary duty to clients still applies when it comes to alternative investments. The complex nature of alternative investments puts an even greater demand on advisers to ensure they are appropriate and suitable for clients, the SEC warns, and that due diligence processes are completed effectively. 

As fiduciaries, advisers who propose alternatives must ensure those investments are in the client’s best interest, meet the client’s stated investment objectives, and are actually managed consistent with the investment principles disclosed by the managers to whom advisers cede control of client assets. As the regulators point out, that’s no easy task when it comes to alternatives, due to the characteristics of private offerings, venture capital, real estate trusts and the complexity of leveraged investment strategies typically roped into the alternatives category.

In developing the Risk Alert, SEC examiners conducted a series of reviews of registered investment advisory firms, pursuant to Section 204 of the Investment Advisers Act of 1940. The staff’s examinations focused on advisers that invested in or recommended private funds or funds-of-funds classifiable as alternatives.

At the industry level, the assets under management for global alternative investments have grown to a record $6.5 trillion, showing a five-year growth rate of more than seven times that of traditional asset classes. But as advisers push more of their clients’ dollars into alternatives, they are only meeting partial success in seeking broader performance and risk information directly from managers of alternatives.

That’s partially because, while some alternative managers are willing to provide additional transparency required for unaccredited investors, others are reluctant to share detail information about their strategies. In particular, the SEC found alternatives managers were sensitive to sharing position-level information, which they felt may compromise their ability to execute proprietary strategies.

The Risk Alert points out that position-level transparency should be pursued by advisers to fine-tune analyses of market sector exposures, to identify position concentrations across their clients’ entire portfolios, and to pick out individual positions that may present risks that are inconsistent with a managers’ stated investment strategy.

The SEC found that the position-level transparency ultimately provided to advisers by alternative investment managers tends to be the result of a process of negotiation between the advisers and managers, and depends on several factors, including the relative influence of the investors and whether the manager viewed position-level transparency as proprietary information.

To ensure they are meeting the due diligence standards required of fiduciaries, regulators suggest advisers should push for separate account management for clients assets placed in alternatives. By securing separate accounts, advisers can provide greater transparency on how client assets are invested. Advisers can also use the strategy to reduce the ability of a manger to misappropriate client money or charge unauthorized fees and expenses.

SEC staff also found that more advisers are utilizing third parties to supplement analyses and validate information regarding alternative investments—which they deemed an encouraging trend. These third-party aggregators are generally service providers that compile detailed portfolio-level information from private alternative investment funds and transmit the data to advisers conducting due diligence. In many cases, the use of an aggregator comes as a compromise between the adviser and the alternatives manager to resolve differing preferences for position-level transparency.

Advisory firms are also turning more and more to third-party service providers to conduct independent background checks on managers and key custodial personnel, as well as to enact regulatory history reviews for broker/dealers and registered representatives. Again, the SEC sees these as important steps in ensuring fiduciary advisers are meeting their obligations when proposing alternatives.

Other important steps for advisers as outlined by the SEC include the use of quantitative analyses and risk measures to detect aberrations in investment returns. Specifically, advisers should be on the lookout for such things as bias ratios, serial correlation and “skewness” of return distributions.

In closing its Risk Alert, the SEC reminds advisers of their responsibilities under Rule 206(4)-(7) of the Advisers Act to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act—and to annually review the adequacy of those policies. The SEC found advisers tend to be weak in terms of annual Rule 206 reviews, the comprehensiveness of disclosures made to clients, and the prevalence of misleading marketing claims and materials.

A full copy of the Risk Alert is available here.

For more on the SEC’s wider compliance initiatives, see “SEC Outlines 2014 Examination Priorities.”