Should You Offer Alternative Investments?

Although the traditional combination of stocks, bonds and cash can provide the majority of investors with satisfactory investment returns over time, an alternative class of investments exists for affluent and institutional investors. These alternative investments can provide an additional measure of diversification and tax benefits that is not available in traditional avenues. Consequently, financial planners who understand and offer this type of investment are in a much better position to land larger and more-profitable clients and accounts. (For background reading, see IRA Assets And Alternative Investments.)

What Are Alternative Investments?
This unique class of investments does not fall into a single larger class alone, such as debt or equities, but can be either one or the other. This class of investments can satisfy many types of investment objectives, such as speculation, tax avoidance, or reduction of overall volatility. Alternative investments can include any of the following, as well as many other specialized investment vehicles that are generally tailored for high net-worth investors:

• individual or managed derivatives
• oil and gas ventures
• hedge funds
• tax shelters
• commercial equipment-leasing programs

Navigating Restrictions And Regulations
Financial planners who are registered representatives (RRs) face a somewhat different set of issues than those who are registered investment advisors (RIAs). Registered representatives are limited to the selection of alternative investments that their broker-dealers have approved, while RIAs have relatively few restrictions to contend with when choosing an alternative vehicle. Registered representatives with clients who want an alternative investment but who have not been approved by the broker-dealer only have one course of action available: the representative must submit the investment to the broker-dealer's compliance department for approval, and hope that:

• the compliance department decides to approve the investment, and
• the entire process doesn't take so long that the RR loses the sale.

Registered representatives are also subject to the rules set forth by their broker-dealers regarding alternative investments, such as what type of client the reps will allow to invest in these investments. Getting around these internal regulations can often be very difficult for brokers, and usually they must get permission from either the head of the compliance department, the president, or vice-president of the company in order to do so. Brokers who cannot get approval for an alternative-investment trade for a particular client are therefore generally powerless to effect the transaction, regardless of how well the client understands the investment and wants it in his or her portfolio. (To read more on this subject, see What Is A Registered Investment Advisor?)

Although RIAs do not have the same restrictions as registered representatives, they are bound as fiduciaries to select the best possible investment for their clients and must assume sole liability if their choice goes awry. But, the only real logistical limitation that RIAs face when choosing alternative investments is whether or not the specific investment being used can be offered on a fee-based platform. If it cannot, the advisor must either become licensed to sell securities and become appointed with a broker-dealer that offers the security, or find a different investment alternative. (Learn more about fee-based platforms in Fee-Based Brokerage: The Latest Target For Regulators and Paying Your Investment Advisor - Fees Or Commissions?)

A possible trend that can emerge from this dilemma is broker-dealers allowing their RRs to act as RIAs in the area of alternative investments only. This allows the broker-dealer to retain its representatives while satisfying the clients' alternative-investment needs.

Evaluating Available Options
Registered representatives who have clients that want alternative investments should ask about their broker-dealer's policy on this matter. Many RRs might have to face the choice of either settling for a different, perhaps less appropriate, alternative investment for their clients or finding a new broker-dealer that will accommodate them. This is more likely to be an issue for brokers who work at major wire house firms, as many of the independent broker-dealers often provide a much more comprehensive array of alternative investments to choose from.

RIAs must weigh for themselves the potential profit and liability of offering alternative investments. For example, an RIA could have several clients who would benefit from a specific type of alternative investment, such as a working interest in an oil and gas project. A single lease that has been carefully researched could provide a substantial source of profit for both the RIA and the clients - and with only a reasonable amount of liability for both.

However, the potential commission or other fee that is charged must always be weighed against any possible consequences that could fall upon the RIA if the investment does not perform as expected. In many cases, this type of decision defies simple mathematical analysis; RIAs must employ common sense and careful due diligence in evaluating the risks inherent in the investment. RIAs must also acquire any licenses that are required to effect the transaction, such as a life insurance license for life-settlement cases.

Conclusion
Offering your clients alternative investments comes with its own set of risk and rewards. RIAs in particular should make a careful evaluation of all pertinent factors before entering into this type of transaction. However, a properly executed transaction of this type can provide clients with a measure of both profit and diversification that cannot be matched by traditional investment avenues, as well as possibly substantial tax benefits. Registered representatives who are just beginning to explore this subject should consult their broker-dealers for more information.

For further reading, see The Pros And Cons Of Alternative Investments.