Advisers Need Education About Alternatives

According to “The FRC Encyclopedia of ’40 Act Alternatives”—a study published on October 16 by the Financial Research Corp. (FRC), a division of Strategic Insight—only 22% of advisers use traditional alternatives with any regularity, and more than 55% use them rarely or not at all.

These advisers have high-net-worth clients; the majority of respondents said at least 5% of their clients are qualified investors. This hints that it is a lack of education that may be preventing advisers from using traditional alternatives, study authors said. Moreover, ’40 Act funds offer a variety of strategies that are suitable for clients who do not qualify as high-net-worth. The fact that advisers are not using these ’40 Act funds suggests that adviser knowledge, rather than client assets, prevents advisers from recommending these new products, Rob Martorana, study author and senior analyst at FRC, told PLANADVISER.

The study suggests a lack of familiarity is preventing advisers from adopting alternatives, although there is no clear pattern to their usage or neglect. For example, gold and precious metals were more popular than managed futures (27% use gold and metals “frequently” or “always,” versus 17% who use commodities/managed futures), despite evidence to suggest the diversification benefits of managed futures.

“It seems that both clients and advisers are sticking to the tried and true, regardless of evidence that new products may offer superior diversification,” Martorana said.

Thirty-five percent of advisers said they “frequently” or “always” use real estate investment trusts (REITs), and 34% said they use any type of exchange-traded fund (ETF) or mutual fund that uses alternative strategies (a liquid alternative). Only 9% of respondents reported frequently or always using hedge funds, private equity and other traditional alternatives.

The implication from these results, the study authors said, is that advisers prefer familiar products such as REITs, which are easy to explain to clients. Thus, fund selection by advisers seems to be driven by familiarity rather than risk/return potential, Martorana said.

When respondents were asked how interested they would be to learn more about traditional and liquid alternatives, 35% said they were “extremely” or “very” interested, while 47% were “moderately” or “slightly” interested, and 18% were not interested at all.

Martorana said he is surprised by the lack of interest from advisers in learning about alternatives. “If you really believe that volatility management [is a challenge], then alternatives are a good solution,” he said, adding that advisers can present alternatives as a way to help clients manage volatility and reach their retirement goals. “Our surveys show that the top priorities of clients are income and reduced volatility. Liquid alternatives can help stabilize portfolios, which is especially important for retirees. Once advisers realize the benefits, they become more interested.”

Until advisers learn more about the benefits of liquid alternatives, it is easy for them to focus on the challenges, study authors said. Respondents cited several challenges to using alternatives, with client familiarity being the top objection (54% reported this was “very challenging” or “extremely challenging”). Other top challenges included complexity (47%), client risk tolerance (47%) and fees (46%).

Challenges can be overcome with education—advisers must familiarize clients with product benefits, showing how liquid alternatives can be used to reduce risk and provide diversification, study authors said. “Slow and steady can be good for education on alternatives,” Martorana said. “If you’re not comfortable with alternatives, start slowly and get educated.”

If an adviser can show clients how alternatives can help, they will learn to overcome objections, he said.  “And when advisers realize that alternatives can help them win new business, they start making time for education,” he added.

For the study, FRC polled 419 financial advisers across the U.S. in June 2012. Contact Kathy Marshall at kathy.marshall@frcnet.com for information about how to purchase the study.