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Don't Invest Your Customer's Money in Alternative Investments until You Have Done Your Homework
lternative investments are the rage. At the end of 2000, there were 6,000 hedge funds worldwide managing $400 billion in assets. Asset growth has risen 13% a year for the last five years, and in just the first quarter of this year, $6.9 billion poured in — the entire amount for year 2000. Even staid mutual funds are joining the party. Franklin Resources has teamed with Auda Group; Oppenheimer Funds bought Tremont Advisers; MFS Investment Management and Zurich Scudder Investments have established internal operations to run hedge funds.
The Problem
My advice to brokers: put on the brakes! Numerous hedge funds have been outright frauds. Consider Ashbury Capital Partners (hedge fund and CEO allegedly falsified financial statements and used millions of dollars of investor funds for personal use), Cambridge Partners (general partner admitted creating false audits, tax documents and monthly statements, defrauding investors of $40 million), Laser Advisers (firm and chairman concealed losses by intentionally overvaluing options in the amount of $71 million and falsifying documents), and the Manhattan Investment Fund (managing partner allegedly concealed losses of $300 million while reporting annual returns of as much as 27%). Other hedge funds have imploded not because of fraud but because of their highly speculative nature. Examples include Red Coat Capital, a long/short hedge fund that lost $250 million of its $375 million by year end 2000, and Gotham Holdings, which lost 90% of its assets on leveraged failed bets on Ibis Technology and MRV Communications.
The Duty
Remember, as brokers you have a duty to perform "due diligence" before you invest your customer's money. In its Policy of the Board of Governors on Fair Dealing With Customers, the National Association of Securities Dealers (NASD) cautions that:
As new products are introduced from time to time, it is important that members make every effort to familiarize themselves with each customer's financial situation, trading experience, and ability to meet the risks involved with such products and to make every effort to make customers aware of the pertinent information regarding the products.
In fact, brokers cannot recommend an investment unless there is an adequate and reasonable basis for the recommendation. By your recommendation, you imply that you have conducted a reasonable investigation of the investment. At a minimum, you must perform that level of examination sufficient to ensure that the investment's offering material contains no incomplete or inaccurate information. In no event can you blindly rely upon representations by the promoters. Should you notice a "red flag" or warning signal, you must be all the more suspect of other claims and representations by the promoters.
Under no circumstances can you deliberately ignore that which you have a duty to know. Nor can you recklessly state facts about matters that you are ignorant. In fact, one court has stated that, when a broker lacks essential information about an investment, he should disclose this as well as the risks that arise from his lack of information.
Likewise, the sophistication of the investor also will affect what you need to discuss with your customers in informing them of the investment. Customers who are uneducated or generally unsophisticated with respect to financial matters will require greater information, and brokers must carefully and cautiously explain the potential risks of an investment. Even if offering material discloses the risks of the investment, you still must ensure that your customer understands those risks.
The Risks
Numerous publications have sounded the alarm with respect to the general risks associated with alternative investments. The best treatment is the Undiscovered Managers' research report entitled "Alternative Investments and the Semi-Affluent Investor" (available on its website). Additionally, in a recent speech delivered to the Public Funds Symposium, Paul Roye, director of the SEC's Division of Investment Management, outlined his concerns with hedge fund investments (available on the SEC's website).
In a nutshell, the risks, or factors to consider, are the following:
- High fees and costs;
- High leverage;
- Low (indeed, no) regulation;
- Low (or no) transparency (indeed, commentators speak of a culture of secrecy);
- Little (or no) hedge fund experience by hedge fund managers;
- High risk of hedge fund manager flame out;
- High risk of deteriorating returns as small, nimble funds attract assets and grow;
- Little (or no) performance history;
- High number of possible conflicts of interest;
- Low reliability in performance reports and financial statements [see Edward Siedle's article, Hedging on Hedge Funds, in the August, 2001 On Wall Street]; and
- Low liquidity and high lock-up periods.
Alternative investments may be just the right cure for an ailing market, but not in large doses and not until after studied carefully. Don't overlook your duty of due diligence.
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Sponsored by James J. Eccleston, an attorney representing stockbrokers, financial planners and
investors nationwide in arbitration, litigation and regulatory matters, and a shareholder with the law firm
Shaheen, Novoselsky, Staat, Filipowski & Eccleston
P.C.(www.snsfe-law.com). This Web site contains material
of general interest. It is neither intended to, nor constitutes, either legal advice or investment advice.
Always consult an attorney and/or investment advisor when building and protecting your wealth.
All content Copyright © 2008 Advocate Capital Management, Inc. except where noted. All rights reserved.
20 North Wacker Drive, Suite 2900, Chicago, Illinois 60606
Telephone: 312-621-4400 | Fax: 312-621-0268
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