Alternative Investments: A perspective on Allocation

By Kenneth Golsan
Movement appears to be afoot among the custodial community seeking to avoid what they are calling “unnecessary risk” posed by various “Alternative” investments.  An “Alternative” is defined as an investment product other than a traditional investment instrument such as stocks, bonds or mutual funds.  Examples are real estate, private equity, venture capital, commodities and hedge funds.  Case in point: Schwab’s February 2009 decision to remove “Alternatives” from their platform by the end of 2009 (indications from other custodians announced or expected).  Why is this happening?

For reasons commensurate with custodians, professional liability underwriters are also increasingly distancing themselves from “Alternative” asset classes.  As specialists in professional liability insurance, Golsan Scruggs has the privilege of seeing a wide array of advisory firms’ investment allocations and insurance carriers’ perspectives on the above mentioned assets classes.  Our firm is seeing an increase in exclusionary endorsements regarding “Alternative” asset classes from our core underwriters.  In most cases, carriers are excluding asset types with concentrated positions; say more than 10 to 15% of AUM in a given alternative class.  Some categories, however, such as hedge funds may be absolutely excluded regardless of the amount of the firm’s exposure.

This is not to say that an “Alternative” investment solution is not the appropriate client advisory strategy; each RIA has a unique clientele, many of whom demand exposure to these assets.  Careful review of this subject is essential as well as an understanding that your professional liability insurance may possess an “Alternative” exclusion or may provide limited defense or indemnification.

So – back to the “why?” – Why are custodians and professional liability insurers shying away from this exposure?  Perhaps they’ve recently experienced a claim or two in these areas?  Most definitely.  Some of the “Alternatives” present an increased level of volatility.  Further, because such assets do not normally receive the same level of third-party analytical scrutiny (in both quantity and quality of analysts) that a commonly traded security receives, whether knowingly or not the RIA therefore retains a greater degree of risk – bearing a heavier suitability/fiduciary load – accepting the responsibility of the assets credit worthiness.

Are the actions of the custodians and professional liability underwriters over-reactions to the chaotic market, or is there more to the story?  Some underwriters have had such a stance toward “Alternatives” for years.  Still, other carriers are rapidly removing or limiting themselves from the exposure.  What should your stance be?  Remember, each insurance contract is different (no standard form) and requires careful review.  As always, we remain available to the RIA community to assist in protecting each firm’s practice properly.