All investment organizations have to make decisions about scope.
The tendency is to branch out into new areas as you grow. For instance, most asset management organizations of any size have multiple products, in many cases ones that are far afield from their original offering. Sometimes the forays stay relatively close to “home,” but it’s common for there to be expansion into different strategies, asset classes, and even philosophies. That naturally brings up questions regarding whether they have the expertise to excel in those new areas — and whether it is more about building assets than delivering value.
A similar evolution can take place within a one-product firm. Many hedge funds are good case studies in that regard, as they move from a single identifiable strategy into others where they see opportunities. An increased pool of assets can also be a contributing factor if the original investment approach no longer produces alpha like it did when the assets under management were smaller.
But another impetus for change comes from the environment. It is hard to resist dabbling in (or diving into) strategies that are at the top of the hit parade in terms of performance (and that are drawing assets). No one wants to be left behind and no one wants to miss a big trend. That’s why mutual fund firms incubate new offerings in hot areas, why thematic ETFs are coming to market ever more quickly, and why previous boundaries that define what an organization does tend to get pushed out over time.
Advisory firms
Like other organizations, investment advisory firms must make choices about scope. It seems like there are plenty of those questions on the table right now, ones that require thinking about investment merit, business opportunity, resource allocation, client segmentation, reputational risk, and more.
Firms that have decided to take an all-passive investment approach (or, as all-passive as possible, since there are always some active decisions in there somewhere) have placed limitations on the scope issue. But, clients tend to have little pockets of other exposures — and prospects may have big pockets of them — so a broader set of information and expertise may be needed to provide transition advice and/or ongoing financial planning.
Organizations that haven’t limited their offerings as strictly face greater pressure from clients (and from investment providers) to take the plunge into areas that they haven’t used before. Often, it’s the most “sophisticated” clients — or the largest ones — that are applying the pressure, which complicates the decision making about how to proceed, since the business risks are (or seem to be) amplified.
Alternatives
Most investments that present these dilemmas fall under the broad category of “alternatives.”
A 2021 article in RIA Intel was titled “White Paper Cautions Advisors on Underexposure to Alternative Investments.” According to it, Cerulli argued that “advisors’ resistance to allocate more money to alternative investments is putting investors at risk.”
That is hyperbolic, of course. Investors aren’t “at risk” if they don’t use alternatives; in fact they are exposed to some unfamiliar risks if they do. But the vehicles are popular and advisors can find themselves in the middle:
“Private markets have grown so quickly, and they’ve become so large, our argument is that advisors have to pay attention. Because if they’re not allocated to [alternative investments], they’re making a bet against these private markets,” Daniil Shapiro, associate director at Cerulli and author of the report, told RIA Intel.
Cerulli’s survey of advisors found that a majority would use more alternatives if they offered better liquidity, but that seems to ignore the fact that “liquid alts” have been a minefield for advisors and their clients (who have paid the price). Be careful what you wish for.
Examples
There is an old saying that hedge funds are “a compensation scheme masquerading as an asset class.” One big change over time: The high-flying performance strategies of years past have given way to approaches that are more likely to be found in a risk-diversifying bucket than a return-seeking one.
Even with that being the case, the aura around hedge funds has lingered, perhaps because of the media attention given to the large personal paydays that some managers receive. (They must be smart!) Historically, the interest in hedge fund investing has been driven both by attractive returns and by the status boost that comes from having access to top talent (and the ability to brag about it).
But there’s a new king of the hill on both fronts — private equity. It is clearly the must-have investment of the day, with wide institutional acceptance and almost-universal expectations that it will offer the best returns around (especially within venture capital, but across the entire range of strategies).
In addition, there is the realm of cryptocurrencies, the sexiest and least understood investment category. Because those digital wonders lack ties to any assets or cash flows, there are many debates about whether they are investments at all.
To offer or not to offer?
Other examples could be cited, all of which pose similar challenges for an investment advisory firm. Here are some of the considerations as to the use of alternatives:
Philosophy. Has your firm positioned itself as one that is quick to expand into new areas or one that is cautious about doing so (or one that responds on a case-by-case basis depending on the clients who are pushing for novel kinds of exposures)? Past positioning sets the frame (although it can be adjusted).
Investment merits. Assessing the prospects for an unfamiliar investment approach can be problematic, since the most prominent advocates for it are those who are directly involved and have something (advice or products) to sell. Therefore, they are also the most conflicted. Separating the analysis of the investment merits from that of the providers and promotors can be difficult, but it is necessary to yield an independent view that truly considers the needs of your own organization.
Circle of competence. Do you have the expertise that is needed? If not, how will you get it (especially since talent is tight and often expensive in specialties that are emerging or very popular)? This comes into play for one-off requests too. The question, “Could you take a look at this private deal for me and tell me what you think?” puts a firm in a tough spot.
Resource allocation. Is it worth allocating resources to something new if that impedes your ability to improve your existing promises/capabilities?
Due diligence. Many alternative investments feature less transparency and more complexity than traditional ones. (In return, you get to pay higher fees.) The due diligence burden is significantly greater for most categories of alternatives, yet many advisory firms struggle to even get past the narrative provided by the managers of publicly-available offerings. They are ill-equipped to go to the next level, which often requires greater investment due diligence expertise and new operational due diligence capabilities.
Client relationships. Navigating the interests/demands of clients regarding access to a range of investment options is tricky. If you don’t push the envelope, you won’t lose clients (or attract prospects) who are less adventurous, but the more aggressive ones could head off to find a firm that will.
Reputational risk. A safe bet is doing what everyone else is doing, which is why most firms look alike. Boldly venturing into new territory could prove to be a major turning point for your organization — one way or the other. Cryptocurrencies are an obvious example; on one end of the spectrum there are very lofty expectations, while on the other, a disaster (AKA “a zero”).
A portfolio approach. Portfolio theory can guide both the construction of clients’ exposures and an organization’s. While an all-or-nothing choice as to whether to be involved at all may be appropriate given some of the items listed above (the need for expertise, resources, etc.), a bet on a new initiative may be able to be sized in ways that limit the damage to clients and to your organization.
Communication. As always, everything rests on objective communication about the range of possibilities that exist. Undue promotion of a new idea increases the pain of failure, as misplaced expectations worsen reactions to unpleasant outcomes.
More to come
A Farnam Street report (not available online) said that “one definition of stress is a mismatch between capabilities and demands.” That’s at the heart of the issue here, and it’s not going to go away. Unless there is a sustained weakness in performance going forward, the demand for alternatives is likely to continue.
Plus, there are new alternative investment platforms coming online, so your competitors will be trumpeting the access that they can provide (and advertising their expertise, real or imagined). And efforts are currently underway to include private equity and cryptocurrency in 401(k) plans; if that happens, your clients will see those as normalized exposures.
To weigh the risks and opportunities in these areas, you need a careful, thorough examination of the variables referenced above, a clear strategy, and the realization that a substandard approach will backfire in the end.
Published: May 2, 2022
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