Why advisors aren't talking to their clients about alternatives

Matt Simpson from Raintree Financial Solutions explains why certain advisors are still clinging to the old model of stocks, bonds and cash

Why advisors aren't talking to their clients about alternatives

In this special guest article Matt Simpson from Raintree Financial Solutions explain why certain advisors are still clinging to the old model of stocks, bonds and cash

Canadians retiring today have a problem. Stock valuations are high and interest rates are low. It is increasingly difficult for investors to find value that can generate sufficient returns to fund their retirements in the way stock and bond investing used to.

In fact, Stephen Poloz, Governor of the Bank of Canada, recommended in a 2016 interview that Canadians should get used to the idea of saving more, working longer and changing their investment mix to adjust to persistently low interest rates.

Institutional investors, such as pension funds or endowments, have increasingly shifted their investment portfolios from stocks and bonds to private assets, generally referred to as alternative investments, to reflect this new reality – more importantly, high-net-worth investors have followed suit. 

They’ve done so because private investments can offer superior, risk-adjusted potential returns over public investments that trade at a premium due in part to the liquidity they provide. While liquidity can be important, rarely do people require 100% liquidity in their portfolio to meet lifestyle requirements. Furthermore, people tend to buy and sell at the wrong time due to behavioural biases, making liquidity a liability in many cases.

Academic research points squarely in favour of adding some private investments to an investment portfolio to minimize risk and improve risk-adjusted returns. So, why are so many financial advisors still clinging to the old model of stocks, bonds and cash (possibly packaged up in mutual funds or ETFs) that hasn’t served their clients particularly well for years?  

I have met with advisors all over Ontario to try to determine the roadblocks to providing investors with an optimal investment mix for today’s reality.  These roadblocks tend to fall into one of three categories:

Additional risk factors:
New sources of risk that require new skills and expertise to manage is a common reason why advisors avoid alternatives. The first risk is the lack of similar regulatory oversight provided to public markets. The exempt market is regulated by the same provincial bodies that regulate the public markets; however, private companies have lower reporting and disclosure requirements than public companies. This lowers costs to raise capital, explaining, at least in part, the growth in private markets. 

The provincial regulators strive to protect investors in the exempt market by having them acknowledge three warnings: 1) You can lose all of the money you invested, 2) You may receive little or no information about your investment, and 3) You may not be able to sell your investment quickly or at all.  All of these warnings are potentially true, but need to be assessed against the prospect of making a return on your investment.

The Ontario Securities Commission legislated mandatory annual audited financial information to be provided to investors for issuances offered under the recently adopted Offering Memorandum exemption.  Many private investments structured as mutual fund trusts contain redemption clauses to ease the liquidity risk, particularly in hardship cases.  While redemption clauses are often restrictive and certainly not as efficient in creating liquidity as selling public shares, the tradeoff for reduced liquidity is typically higher potential returns.  

An advisor with knowledge and access to the private markets can help an investor understand the degree of liquidity offered by a given investment.  Finally, with any equity investment it is true that an investor can lose all the money invested – but this is true regardless of whether that security is listed on a public exchange or held privately.  This is why diversification and proper selection is so important.

Lack of expertise from the advisor’s dealership
The expertise required to source, evaluate and monitor private investments is significant.  Planning a portfolio can be tricky when using private or alternative investments.  One of the biggest challenges for an unsuspecting investor, for example, is distinguishing between a registered securities dealer and an unregistered salesperson operating illegally (investors can check aretheyregistered.ca to determine if their advisor is registered).

Aside from finding a qualified advisor, there is a wide range of structures where business model, management team, commissions, profit sharing, and use of capital are concerned.  An advisor whose firm does not have expertise in evaluating private investments is unlikely to recommend a product to his or her clients regardless of the actual risk / return profile for fear of making a poor decision.  It is often easier to ‘play it safe’ than to acquire the expertise and resources to understand a new investment, which then limits an advisor’s ability to offer full diversification to their clients.

Economic disincentive
Incumbent wealth management firms with large investments in the infrastructure that supports more familiar investments such as stocks, bonds and mutual funds need to spend significant capital to develop new lines of business.

Such new lines of business serve only to cannibalize existing lines of business as funds are redirected from current products (e.g. mutual funds) to the new investments. In other words, adding a new line of business is, for the most part, an exercise in incurring significant cost without much gain.  As a result, such firms typically wait until the market gains sufficient scale and demand is proven before developing or acquiring the infrastructure and expertise required to serve an emerging market opportunity. 

Another example of economic disincentive relates to the commissions advisors receive for executing trades. With many more liquid investments, advisors can ‘churn’ their clients’ portfolios, earning commissions by selling one security and buying another.  Churn can be highly profitable for an advisor and their firm, but not always in the best interest of the client.  Private assets do not provide this ability for advisors as once the client is invested; it is generally fully invested until the fund/company exits in the future – limiting the ability for churn in the portfolio.

Finding an advisor with expertise in private investing and a track record to match is essential for long-term wealth creation in the current environment. 

Matt Simpson is Vice President, Ontario Region at Raintree Financial Solutions Inc.

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