Why dealer firms favour 'plain vanilla types' of investment offerings
Amid headwinds to both equity and fixed-income markets this year, financial advisors and portfolio managers see a growing case to expand or increase their allocations to alternative investments. Still, many are not getting the level of exposure they want or need.
According to the Alternative Investment Management Association (AIMA) Canada, most dealers have relegated alternative investments to high risk ratings, even if they do not reflect a particular fund’s historical risk-adjusted return. While dealers are slowly adopting more favourable ratings based on guidelines put forward by AIMA and the Canadian Alternative Industry Association (CAIA), the progress of adoption has been slower than advocates have hoped.
Vipool Desai, president of Ara Compliance, says part of the problem lies in the conservative approach many dealer firms take in building their approved product shelves.
“The risk management or product committee at a dealer firm are the bouncers who decide which funds get on into the club (aka their dealer network),” says Desai (pictured above, left). “Unfortunately, the due diligence checklists and processes they use typically favour larger established fund manufacturers and plain vanilla types of investment offerings. Often the committee’s focus is on minimizing enterprise risk.”
According to Desai, innovative funds or funds issued by niche manufacturers are likely to run up against two obstacles. First, if the dealer has an equivalent on their shelf, either proprietary or from a larger manufacturer, there’s no incentive for them to entertain another offering that is perceived to be similar.
“The second and greater challenge,” Desai says, “is that dealers are getting awfully sensitive about reputational risk. They tend to favour funds issued by large established manufacturers, even if deeper due diligence reveals these funds aren’t the best or most cost-competitive. If a fund fails, there can be significantly greater backlash if the manufacturer is not a well-recognized household name.
“For many advisors, that raises the appeal of having their own firm,” he adds. “They can decide on their level of risk. They can make recommendations as long as they understand the alternative product. But as long as they’re part of a firm, the head of the risk management or the product committee gets to decide.”
For its part, AIMA Canada is continuing to push for greater adoption of alternatives by engaging with regulators and key dealers. Claire Van Wyk-Allan, managing director and head of Canada at AIMA, says the association consistently meets with members of the Canadian Securities Administrators (CSA), the Investment Industry Regulatory Organization of Canada (IIROC), and the Mutual Fund Dealers Association of Canada (MFDA).
“We want to make sure regulators understand the importance of alternative investments within portfolio construction for the end investor, as well as the burdens and challenges that processes like the client-focused reforms pose to the distribution and fair access to independent products in Canada,” Van Wyk-Allan (above, right) says.
AIMA also has close relationships with the top 10 IIROC dealers by size for alternative fund distribution, as well as with numerous other dealers and multifamily offices and select advisors directly. To help spread awareness and increase understanding, the association has created multiple resources to educate advisors and the firms, including 5-minute videos, infographics, presentations, whitepaper and guides.
“Dealers need to embrace proper due diligence, product training, and education of their advisors and generate awareness about how to assess features and risks of strategies and managers and their governance control frameworks,” says Belle Kaura, the chair of AIMA Canada.
“The industry needs to make due diligence on all products more mainstream and more standardized so that advisors become skilled at assessing alternative funds,” Kaura says. “Greater familiarity on how to assess alternatives and risk ratings that match actual risk of funds should lead to alternatives becoming a bigger share of retail investor portfolios.”
According to AIMA, some dealers are proactively encouraging their advisors to take the course on alternative investments offered by the Canadian Securities Institute. The association has also published a due diligence guide setting out specific questions advisors should ask on hedge funds, as well as particular aspects of private credit.
“At the end of the day, financial literacy for the Canadian end-investor is important too,” says Van Wyk-Allan. “All of us – industry regulators, dealers, and associations – can help increase the level of comfort and education for the Canadian investor so that they understand the benefits and risks that alternative investments can provide to portfolios.”