Many independent investment advisors are doing a poor job of due diligence on alternative investments, according to a survey taken this week by Advisor Products. 

A majority of respondents to the survey, 63%, say they have no formally documented due diligence process, and 54% say they do not have a consistent "standard" list of documentation that they collect from alternative investment managers before investing to support their due diligence process.







Astonishingly, 76% of the advisors surveyed say they are not confident that they possess the necessary skills to fully vet all the risks associated with allocating to alternative investments (AI).







The survey is not scientific. Only 67 firms responded. However, in similar surveys conducted by Advisor Products over the last decade, the survey results change little whether 67, 167, or 1670 advisors respond. Once 35 advisors respond to such surveys, overall results generally remain consistent as the number of respondents grows.







News that advisors poorly handle due diligence of AI could not have come at a more poignant moment. Bernard Madoff today pleaded guilty to 11 counts of fraud, money laundering, perjury, and theft in federal District Court in lower Manhattan, admitting to crimes carrying maximum terms totaling 150 years. (Click picture above for 1m:46sec video.)







Madoff, who ran a BD and hedge fund, who bilked investors out of tens of billions of dollars over 20 years in the biggest Ponzi scheme ever, thus becomes the biggest swindler in history. At a time when Main Street resents Wall Street more than ever in American history, Madoff has caused lasting damage to the notion that financial advisors are trusted counselors.







Moreover, the data suggesting that advisors are not adequately performing due diligence on AI comes just as Schwab Institutional, the nation's largest custodian of RIA assets, has announced that it would soon require the 5,500 advisors that custody assets on its platform to transfer all alternative investments off its system to another custodian.















Schwab Institutional on February 18 had announced that it would immediately on that same day stop accepting any new offshore and domestic AI assets, and after April 30, would no longer accept additional investments in AI deals currently held at Schwab. The announcement provoked an uproar by advisors, which apparently convinced Schwab to modify course today. A Schwab spokesperson says that advisors will now have months before it will must stop making additional investments in AI deals currently held at Schwab--provided that the AI assets meet new "acceptance criteria." Schwab says the acceptance criteria are not yet worked out.
















Schwab's new policy says advisors won't have to move any of their AI assets until later this year, after Schwab has built an interface to a sub-custodian. For now, it is referring RIAs to two sub-custodians, Pensco Trust Company of San Francisco and Sterling Trust Company of Waco, Texas. Once the interface is complete, allowing advisors to download data about holdings at the sub-custodian to present a consolidated statement to their clients, a Schwab spokesperson says, Schwab will follow through on its plans to require that all AI investments be moved off its system.







Tom Anderson, president, CEO, and founder of Pensco, agreed to participate in a previously scheduled webinar Friday sponsored by Advisor Products about AI due diligence. The webinar, part of the Financial Crisis Webinar Series, will be held at 4 p.m. EST Friday and advisors can register for the free session here. Jason Scharfman, a due diligence consutlant and author of Hedge Fund Operational Due Diligence, is the featured speaker at the session.







With the regulators becoming much tougher as a result of the subprime mortgage crisis and string of frauds now coming to light as a result of the sudden, steep drop in asset values, Schwab had little choice but to find a specialist custodian for RIA AI assets. Other big custodians do not hold AI assets because of the operational and investment risk they entail and the complicated service model they require.







"We have a platform we've built for 20 years that has been designed around AI and not around traded assets, " says Anderson, who says he previously owned a B/D and had been a top executive at Bank of America's trust company. "When you trade shares of IBM on Schwab's system, it passes straight through to Schwab without touching human hands. That is totally different from AI.









"It's all hand-done on our platform," says Anderson. "It requires different personnel, controls, and systems, and none of the B/Ds can match our systems, and they can't just throw money at it to patch it on to a large enterprise."







Capital requirements imposed on B/Ds holding AI assets are different from custodial banks, making his firm more attractive to hold the assets. In addition, regulators are pressuring institutions to find ways to ensure AI assets are handled in ways that can lower the risk of Madoff-like disasters in the future. The SEC and FINRA are not set up to monitor AI or hedge funds, and state banking authorities that monitor trust companies are more familiar with ensuring controls and procedures are in place to custody two acres in Idaho held in a trust account. Schwab is likely acting to head off actions by regulators who are expected to clamp down on AI in the months ahead.







Schwab advisors should expect custody fees to rise on their AI assets. Smaller trust companies that specialize in AI custody, like Pensco ($3.3 billion) and Sterling ($4.8 billion), are likely to charge more for their services than Schwab. Moreover, Schwab was able to afford to take a loss or make no money on custody of AI assets and hold the assets as an accommodation to an RIA. Since the largest RIAs are the ones most likely to hold AI positions, Schwab could bury higher costs associated with administering AI positions in the total fee paid by an advisory firm for custody. With its mutual fund supermarket platform for advisors being the source of huge profits, Schwab could afford to run the AI custody business as a loss leader.







Schwab's February announcement was clearly a major mistake that angered many of its biggest and most valuable RIAs. Its timing—which would have forced awkward calls to clients to explain a sudden change in custodians—could not have been worse. At a time when Madoff is being tossed into jail and investors in AI are already nervous about their holdings, forcing such a sudden transfer from Schwab to an osbcure custodian that they never heard of before would have only heightened fear among RIA clients and increased pressure on advisors already strained by the worst economic calamity since The Great Depression.







Despite its clumsy handling of the AI issue, Schwab should be applauded for seeing its error and changing its course. That's a lot more than you can say for RIAs who may be exposing their firms to great risks by failing to fulfill their obligations as fiduciary to do proper due diligence--even as Madoff is sent to jail and other hedge funds blow up each week.







As an observer of advisors, I'm concerned about how AI due diligence is being handled by RIAs.







The picture to the right is your house, Mr. and Mrs. RIA. It's burned down.







Sadly, I'm seeing some advisors so caught up in their own pain that they are wallowing in self pity or, worse still, acting lazily.







Yes, you're looking at taking a massive hit to your income. Your house is torn asunder. But do yourself a favor and don't spend even a minute of your precious time feeling sorry for yourself. It's done. Move on.







Either you adjust to changes in the economy, accept your responsibilities, and manage your firm strategically now, or you risk being swept up in the turbulence and spit out by it. And who knows where you'll land?







Independent advisors are incredibly lucky, despite the fee slashing they're taking right now. You are where the puck is going. Wall Street's behemoths have no credibility. Most IA's say they are bringing in more new clients than they're losing.







Either you are going to get on top of the due diligence issue and create systems and processes and address due diligence on these assets, or you will leave yourself open to lawsuits if AI assets in which you invested client money turn bad. The danger is that many AI deals that started out as legitimate have become Ponzi schemes as losses have mounted. That's why acting now to perform due diligence is so critical.







If the survey we took is close to accurate and many advisors don't even have documented processes for conducting due diligence, then their exposure could be great. At least if your RIA performs basic due diligence and documents it, the firm will have a defense if an AI holding blows up. By doing no due diligence, a firm ignores its responsibility as a fiduciary and is subject to greater exposure and liability.







Last week, the Financial Crisis Webinar Series featured business coach Sharon Hoover in a great session. The webinarinvitation drew advisors by promising that Hoover would speak about how advisors can better manage the stressors they are now facing. About 500 advisors registered to attend. This week, we only have about 150 registrants so far. That's sad.







Seems like advisors are more interested in whining and wallowing and not so interested in learning how to correct the due diligence problem. That's scary.