Although traditional stocks, bonds, mutual funds and other similar vehicles can accomplish many basic objectives for your clients, there are times when you can get them better results by looking outside the box. Alternative investments can provide superior returns or other benefits that cannot be duplicated by traditional offerings in many cases, but they also come with a commensurate level of risk and uncertainty. Financial advisors who recommend these investments should always begin by thoroughly researching the offering in question and performing rigorous due diligence on all parties involved.

The Perils of Alternative Investments

Investment options that are not publicly traded often exist outside the direct jurisdiction of regulatory authorities such as the Financial Industry Regulatory Authority (FINRA). And while many of these private enterprises can be very lucrative for those who qualify to invest in them, they also contain potential pitfalls that both advisors and their clients need to understand before signing on the dotted line.

In general, alternative investments are usually designed to enhance returns and reduce the overall risk of a large investment portfolio by investing in non-traditional offerings. Some alternative investments are also designed to produce a return on capital within a specific range or generate substantial losses that can be written off against other types of income. But in many cases, such as with many private equity opportunities, they offer little or no liquidity along with the possibility of large losses, and it may also be difficult to obtain accurate or complete information about their inner workings. (For more, see: Investing in Alternative Mutual Funds and ETFs.)

A good percentage of the investment choices in this category are also too complex for most clients to understand except in a very general sense, which requires them to put a greater level of trust in those who recommend them. Many alternative offerings also come with high fees and expenses and may offer little or no tax efficiency. Assigning a definite monetary value to them may also be difficult. For this reason, alternative recommendations can come with a greater level of liability for advisors. (For more, see: Minimize Your Losses with Alternative Strategy Funds).

Do Your Homework

Due diligence for alternative investments is somewhat different than it is for something that is publicly traded. Whereas the latter type of offerings typically come with a prospectus that contains all relevant information about the security, advisors must often conduct their own examinations of alternative offerings. (For more, see: Want To Impress Clients? Show Your Due Diligence.)

The managers who run alternative funds or other investments need to be investigated closely, along with anyone else who plays a material role in the operation of the fund. Get a complete work history, list of references, past professional accomplishments and track record of investment performance if applicable. And, of course, run checks on each of them with all of the appropriate regulatory agencies to get their disciplinary history.

For the investment itself, get a list of all individual holdings that it contains for any type of fund as well as all historical performance data. Then dig deeper by finding out whether the company or investment vehicle is paying out more to investors that it is earning. If it is, then this means that it will face a deficit at some point, which could lead to future losses. Another key issue is pricing. How is the fund or investment determining its price? Do they use an uninterested third party, such as a CPA or accounting firm to assign them a value? How is price movement measured? Finally, do the people who are offering or managing the investment in question own any portion of it themselves? Advisors should probably look with suspicion on those who don’t. (For more, see: Are Hedged Mutual Funds for You?).

Tax Reporting

Return on capital isn’t the only issue that advisors need to research before showing an alternative offering to clients. These vehicles often function in gray areas of the tax code in order to bolster returns or reduce reportable income. Will the investment generate all of the tax forms needed for reporting, or will the clients have to do the math themselves? Are the passive losses that are promised by the venture going to be accepted by the IRS? Has the investment or its clients had any problems with tax reporting in the past? (For more, see: Getting to Know Hedge-Like Mutual Funds).

Know Your Client

Just because a client qualifies for an alternative offering on paper doesn’t mean that they are necessarily suited for it. Risk-averse clients are probably best left out of this arena, and those who tend to ask lots of ongoing questions about their investment portfolio may take up more of your time than they are worth if you put them in a complex instrument of any kind. As with any type of investment, clients need to feel comfortable about what they are doing here and understand the types and levels of risk involved, and they should be able to weather a realistic worst-case scenario. (For more, see: 5 Vital Questions Advisors Should Ask New Clients.)

The Bottom Line

Alternative investments can provide unique benefits to clients for whom they are suitable, and recent surveys indicate that they are increasing in popularity. But they typically do not offer the same level of transparency and liquidity as their publicly-traded counterparts and may be subject to special risks and hazards. Although the Dodd-Frank Reform Act has brought these offerings further under the jurisdiction of the SEC, they are still far less regulated than mainstream investments and must be approached with caution. (For more, see: How to Invest Like an Endowment).

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