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SEC Document Seeks More Transparency



Demand for alternative investments by financial advisors in search of higher returns has caused the Securities and Exchange Commission (SEC) to issue a “risk alert” regarding advisor due diligence in accordance with the Advisers Act.

The nine-page document is targeted mostly at institutional advisors and pension consultants, but still provides a peek into what SEC examiners have uncovered during spot-checks of advisors nationwide.

Under the rules of fiduciary duty, advisors are duty-bound to act in the best interest of their clients and many advisors work hard to vet their managers.

Even so, there’s no shortage of give and take, and plenty of room for compromise between advisors and managers over client accounts and the transparency of investment positions, examiners from the Office of Compliance Inspections and Examinations (OCIE) said.

Advisors are seeking more information directly from managers of alternative investments with regard to “position-level transparency,” or the positions taken within alternative investments, the OCIE found, but there’s no guarantee managers will reveal position details to advisors.

Some investment managers share detailed investment information but others do not, the examiners found. While some advisors recommend that client assets be managed within a separate account, many asset managers prefer a “pooled structure” because pooled strategies are cheaper and more efficient.

“As with the degree of position-level transparency, the staff noted that the resulting investment structure was increasingly determined through a negotiation between managers and advisers,” the OCIE said.

More advisors are using third-party portfolio aggregators to supplement and corroborate analysis of alternative investments, the examiners said. In some cases, the use of portfolio information aggregators is the result of a compromise between advisors and managers with regard to “differing preferences for position-level transparency,” examiners also said.

By and large, financial advisors are conducting serious inquiries into alternative investments and the relationships of those investments to administrators, custodians and auditors, OCIE examiners said. In some cases, advisors refused to recommend investments in alternative funds lacking an independent third-party administrator.

The checks and balances provided by independent administrators are seen as a good way to mitigate the misappropriation of assets. Advisors conduct routine background checks and regulatory reviews of FINRA-registered broker/dealers, the examiners also found.

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In addition, advisors are performing more quantitative analyses and risk measures on alternative investments compared to past examinations, the OCIE found. These analyses include “detection of manipulation of performance returns.”

Furthermore, advisors are expanding their due diligence around the review of legal documents, fund redemptions, on-site visits and financial statement audit, examiners said.

OCIE examiners also said that when advisors encounter certain behavior, it raises a red flag and sets off warning indicator lights.

Alarm bells include investment managers unwilling to pass along investment holdings information, meager research, turgid investment processes, returns uncorrelated with a manager’s investment strategy, and little or no segregation of duties between investment activities and “business unit controllers,” OCIE examiners also said.

Portfolio holdings with high concentrations in a single position or sector, investments left to drift, complex or opaque investments and investment strategies, inexperienced auditors, unqualified administrators, brokers with a checkered regulatory history, and undisclosed conflicts of interest constitute yet more warning signs for advisors, the examiners said.

Alternative investments — alternatives to traditional investments such as stocks, bonds and cash — have gained attention in recent years as a way to boost returns of fixed-income portfolios suffering in an era of low interest rates.

A fixed-income portfolio of $1 million yielding 2.5 percent annually generates $25,000. Take that same portfolio, boost it with one or more alternative investments for a little more risk, and have it yield 3.25 percent, and the portfolio will produce $32,500 annually.

Common alternative investments include commodities, precious metals and even some mutual funds investing in narrow or illiquid economic sectors.

OCIE examiners also said they had found “material deficiencies or control weaknesses,” among advisors themselves, all of whom are required to implement written policies and procedures under Rule 206(4)-7 of the Advisers Act.

Deficiencies include the failure to perform due diligence and implement procedures around alternative investments when alternative investments constitute a major part of their business. Some advisors also failed to review disclosures “for consistency with fiduciary principles.”

Other institutional advisors misled investors with regard to marketing claims by overstating the number of research analysts working for the advisor, OCIE examiners also found.

is a writer based in Pennsylvania. He has covered the financial services industry for more than 15 years. Cyril may be reached at

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