Do Your Due Diligence: An Update on Alternative Investments

By Benjamin Stubbs, Spring 2014 Student Intern

homeworkWe all face risks in life, everyday.  There’s no way around that.  What makes most of us, or at least me, more comfortable in facing risk is having a clear understanding of what the risk is, at least that way we’re not caught off guard and it’s easier to recover when something unplanned happens.  Investing is similar.  It’s risky, and there’s no way around that.  As I noted in a previous post, alternative investments are even riskier than traditional investments.

Some have said that the field of alternative investments feels like the Wild West because so many new products have been introduced lately.  Accordingly, FINRA and SEC have decided to focus studies on those who sell or advise clients on alternative investments, and on January 28, SEC issued a risk alert to advisors on the due diligence that advisors should perform when they recommend or buy alternative investments for clients.  Though the alert will not decrease the risk involved with alternative investments, it can help us get a better understanding of the risks involved with alternative investments before we invest in them.  That way, if we choose to invest in them, we can do so more comfortably and better prepared.

What did SEC say?

In its alert, SEC noted several positive things many advisors are already doing before recommending or buying alternative investments.  Advisors are getting more information about alternative investments directly from those who manage the investments.  They are verifying and supplementing the information they get from managers by talking to third parties, and many advisors perform further analysis and risk assessment of the investments and of their managers.

SEC also noted some “deficiencies in several of the advisory firms examined,” however.  For example, some firms do not review their due diligence regarding alternative investments to make sure they are doing a good enough job investigating them.  Some firms give customers misleading information about how well they investigate alternative investments, and some firms’ due diligence practices differed from what advisors had told their customers the firm was doing.

What does this mean for you?

If you have an advisor and are invested in or thinking about investing in alternative investments, talk with your advisor about SEC’s alert.  Ask if he or she, or the investment firm, has performed proper due diligence by investigating the alternative investments that you are or may be invested in.  Ask specifically if he or she or the firm has completed each of the positive steps noted by SEC, and ask to see the firm’s policy on due diligence regarding alternative investments.

If you do not have an advisor, the alert can still help you because you can perform your own due diligence by completing the positive steps SEC noted.  Before investing in an alternative investment, talk with the manager of the investment.  Then, talk with third parties to verify what the manager told you, and, as I mentioned in my previous post, find out as much as you can about the investment and its manager.

Encounter risk wisely.

It’s worth repeating that alternative investments are risky, and even the most thorough due diligence will not eliminate the risk.  Proper due diligence can ensure, however, that you have a much better idea of exactly what you’re getting into, and knowing what you’re getting into can prevent you from making mistakes that may be harmful to your investment goals.