The alternative marketplace is changing. Not only are alternatives gathering renewed momentum among institutional and high-net-worth (HNW) investors, but there is also growing interest from financial advisors and their clients.
Demand for alternatives from this largely untapped retail channel is chiefly responsible for this evolution in both product structuring and the methods of distribution. Asset managers are focused on creating new alternative investment products to appeal to this channel, while financial-technology (FinTech) firms and supporting financial services companies are focused on creating new online marketplaces with the goal of helping a wider range of investors access and understand these products.
There are a multitude of alternatives, each with its own unique risk and return characteristics. Over the last decade, new product structures like alternative strategy mutual funds (‘40 Act funds) and exchange-traded funds (ETFs) have been created for investors that would like to access alternative investment strategies but prefer a more familiar, liquid structure.
While asset managers continue to develop new products to meet investor demand for alternative strategies and help raise awareness and further interest in alternative investments in general, financial advisors and individual investors still cite a number of challenges that often prevent them from investing in alternatives. According to a recent report by Cerulli, the three leading challenges are:
- Educating clients on the complexities of these strategies
- Poor or underwhelming performance
- Dealing with tax implications
Regardless of the challenges, almost half of financial advisors around the world agree that traditional portfolio allocation (stocks, bonds, and cash) may no longer be the best way to pursue returns and manage investment risk for most investors, according to a 2013 study by Natixis Global Asset Management. Consequently, about three-fourths of these advisors (primarily in the United States) have had conversations with clients about alternative investments.
Methods of Distribution
A few decades ago, technology revolutionized the way individual and professional traders invested in traditional assets. Online trading platforms brought the capabilities and comprehensive research, once the exclusive domain of professionals, to the masses.
The recent financial crisis played an important role in setting the stage for the next ‘game changer’ and technology, yet again, leads the revolution.
The FinTech industry and supporting financial services companies together are rethinking the methods of distribution for alternatives. They are creating new offering platforms and portals in an effort to address the key challenges that investors face. These platforms aim to not only provide access to alternative investments and research, but many offer components to educate.
Alternative Asset Custody
Just as the alternative asset marketplace is being reshaped, innovative financial services companies are reshaping to better serve meet demand. Custodians are working closely with many of these platforms and portals to provide a range of custody solutions that not only support their underlying business models/infrastructure but provide custody for both individual and institutional investors.
The most basic responsibilities of a custodian are not changing but the ways in which their services are being delivered and how the assets are being accessed, documented and held is evolving.
In 2009, after a series of high profile cases of fraud, the SEC amended Rule 206(4)-2 under theInvestment Advisors Act of 1940. The SEC’s intent was to strengthen the existing Custody Rule, in an effort to deter the misappropriation of client assets or the misrepresentation of the ownership of those assets by RIAs; attempting to limit the ability to defraud investors. Essentially requiring that a qualified custodian play the middle-man, between investors and investment advisors; maintaining custody of the assets and providing the investor statements where required.1
The amended Custody Rule outlines the following key requirements for advisors:
- Annual surprise examination of the RIA by an independent public accountant
- Use of a qualified custodian to hold client cash and securities as well as to send periodic account statements directly to the client, with certain exceptions
- In regards to limited partnership, LLC or other type of pooled investment vehicle, if not using an independent qualified custodian the RIA is responsible for (i) engaging an independent PCAOB accountant for the audit of the advisor and (ii) providing a written, internal controls report related to the controls upon custody of client assets by the advisor or a related party which is also verified and reconciled by a PCAOB accountant.
The core role of an independent qualified custodian is to hold cash and assets on behalf of a client and, with certain exceptions, to send required periodic account statements directly to the client. While all qualified custodians are meant to fulfill this same function, some innovative companies are also able to offer specialized services and create custom solutions for custody of new or unique assets.
No one knows what the final version of this new emerging marketplace will eventually look like. Investor demand for alternatives and recent regulatory changes are driving significant change into all areas of the industry. Technology is set to play an increasing role in helping to change the way we invest in alternative assets while, continuing to comply with regulatory requirements and address concerns about the safekeeping of client assets.
1.PwC, FS Regulatory Brief: How the SEC’s Custody Rule Impacts Private Fund Adviser, p. 1, 2011 [http://ngam.natixis.com/docs/140/637/WP87-1213_FA_Survey_WP_F,0.pdf]
Reggie Karas is Senior Vice President, Managing Director of Alternative Solutions Group, Millennium Trust