Practical analysis for investment professionals
05 January 2012

Trust is in the Details: Why Advisers Need to Close the Knowledge Gap on Alternative Strategies

“Trust in me, in all you do.
Have the faith I have in you.”

These lines from the song “Trust in Me,” which was popularized by Etta James, should be the anthem that investment advisers sing to their clients. After all, trust is the foundation of any long-term business relationship.

Unfortunately, many clients are singing “Liar, liar, pants on fire” after the market meltdown in 2007–2008 and the resulting financial scandals. If you sort through the wreckage, you will see that some advisers were recommending investment products and strategies — to institutions as well as individual investors — that neither they nor their clients understood. Although investors must take some responsibility for the choices and decisions that were made, the bulk of the responsibility lies with their investment advisers.

Today, as the markets continue to reel from the financial crisis, investment advisers looking for returns in a low-to-no-return environment are showing an increased interest in alternative investments — even though many advisers admit to having limited knowledge about these investment products.

Case in point: In advance of their first Alternative Investment Conference, Investment News surveyed a group of investment advisers about alternative investments and uncovered a few disquieting statistics. Among those advisers surveyed…

  • 52% felt they were not as knowledgeable about alternative investments as they’d like to be;
  • 88% felt very comfortable discussing alternatives with their clients;
  • 89% were using alternatives in their clients’ portfolios.

Does this mean that investment advisers are recommending alternative investments to clients that they themselves don’t fully understand?

Unfortunately, I think the answer in many cases is yes.

To be fair, the term “alternative investments” is very broad. It includes assets such as commodities, real estate, gold, energy projects, and structured finance, to name a few. Alternatives also encompass hedge funds, private equity, and venture capital, as well as portfolio mandates designed to take advantage of both price increases and decreases in underlying assets. Alternative investment managers often navigate illiquid and opaque markets, making it especially tough for investors to get a sense of the value of the asset prior to a liquidity event. Navigating the complexity of such broad-ranging, diverse, and often niche markets leaves many investors and advisers unsure of themselves.

Still, if the investment community is to ever regain the confidence and trust of  clients and the public at large, we have to do a better job of understanding and communicating the features, characteristics, and risks of the investment products and strategies that we are recommending. As investment professionals, it is our duty to determine whether an investment is suitable given our client’s financial situation, and is consistent with their written objectives, mandates, and constraints. We must exercise diligence, independence, and thoroughness, and have a reasonable and adequate basis — supported by appropriate research and investigation — for any investment analysis, recommendation, or action.

Trust is the foundation of long-term relationships (both personal or professional!), and open and effective communication is one way to build trust. Therefore, it is imperative that we develop and maintain clear and frequent communication with clients. When clients understand the hows and whys underlying our recommendations, it provides them with the opportunity to make more informed decisions.

Put another way, knowledge allows us to communicate more effectively with our clients, and that in turn enables clients to have trust and faith in all we do as investment professionals.

Continuing education is key, and there are a number of online resources on alternative investments to help investors and advisers alike enhance their knowledge base.

Additional Resources

  • Commodities as an Investment: In this article, Gerald R. Jensen discusses the instruments that provide exposure to commodities, the measures and historical record of commodity investment performance, evidence about the benefits of strategic versus tactical commodity allocations, and recent developments in the market.
  • An Incommodious Commodity?: Stephen Mauzy, CFA, outlines some of the misconceptions about gold that can lead analysts astray in this article from the May/June 2011 issue of CFA Magazine.
  • Alternative Investments Portfolio Management: This chapter from Managing Investment Portfolios: A Dynamic Process outlines the six groups of alternative investments.
  • Alternative Investments Overview: In this video webcast, Charles Robinson from HSBC Global Asset Management discusses how alternatives are increasingly being viewed as mainstream.
  • The Next Stage in the Life Cycle for Alternative Investments: Robin S. Pellish discusses the evolution of the process of allocating risk capital to alternative strategies in this audio podcast.
  • Russell Investments 2010 Global Survey on Alternative Investing: This survey highlights institutional investor allocation trends to alternative investments.
  • Handbook of Alternative Assets: This book examines the most popular types of alternative investments and provides a detailed explanation of these strategies and investment vehicles.
  • Investing in Private Equity: In this podcast, Mark D. Wiseman discusses the prospective correlations of private equity investments with other asset classes and allocations in the total fund.

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About the Author(s)
Michael McMillan, CFA

Michael McMillan, CFA, is director of ethics education at CFA Institute, where he is responsible for creating, sourcing, and developing educational content for CFA Institute members and investment professionals in the area of ethics and professional standards. Previously, he was a professor of accounting and finance at Johns Hopkins University’s Carey School of Business and George Washington University’s School of Business. Prior to his career in academia, McMillan was a securities analyst and portfolio manager at Bailard, Biehl, and Kaiser and at Merus Capital Management. He is a certified public accountant (CPA) and a chartered investment counselor (CIC). McMillan holds a BA from the University of Pennsylvania, an MBA from Stanford University, and a PhD in accounting and finance from George Washington University. Topical Expertise: Financial Statement Analysis · Standards, Ethics, and Regulations (SER)

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