For all the hype around alternatives -- and there is no shortage -- investment advisors should take note that regulators are watching how the investment advisors are handling hedge funds, private equity funds and other non-traditional asset classes.

The SEC signaled its concerns about alternatives in the guidance it issued in early January outlining examination priorities for the coming year. Then, not three weeks later, the commission published a risk alert offering considerable detail about the precautions that advisors might consider before recommending that their clients go into alts.

The SEC notes that it has been watching the alternative space for at least the past six years, citing a 2012 McKinsey study that pegged the global value of alternative investments at $6.5 trillion, the product of a five-year growth rate more than seven times higher than traditional assets.


So what is the SEC concerned about? The risk alert warns that advisors must conduct due diligence in evaluating alternatives -- complex assets that can be difficult to value, illiquid and pricey -- to ensure that they are a good fit for clients and that the promotional materials offered by the fund manager check out.

"An adviser that exercises discretion to purchase alternative investments on behalf of its clients, or that relies on a manager to perform due diligence of alternative investments, must determine whether such investments meet the clients' investment objectives and are consistent with the investment principles and strategies that were disclosed by the manager to the advisor," the SEC writes.

When dealing with alternatives, advisors' due diligence responsibilities are implicated by their fiduciary duty under longstanding statute. But in that area, it is primarily their fiduciary duty of care and the obligation to recommend investment strategies that are suitable for clients -- rather than the more familiar duty of loyalty -- that come into play, according to Duane Thompson, senior policy analyst at the fiduciary training organization fi360.


"Whether the SEC realizes it or not, it's getting more into the duty of care and suitability," Thompson says. "In some ways this is, I think, new territory for both the SEC and for advisors in terms of suitability requirements."

To be sure, the duty of loyalty still holds, Thompson and the SEC both note, which means that disclosures of any potential conflicts of interest involving alternatives are imperative.

But in the murky and vaguely regulated arena of hedge funds and private equity funds, the SEC seems to be sending a message that advisors should go above and beyond normal due diligence to ferret out position holdings, confirm the claims in marketing materials and, potentially, run broker and background checks on managers -- a vetting process that some advisors are outsourcing to a third party.

"Alternative investments, hedge funds, etc. are more opaque. It's not your mother's pooled fund that you can purchase at Vanguard," Thompson says. "If they're going to get into alts, there's no excuse for not doing due diligence, whether you're a large firm with $1 billion under management or $60 million."

Does all of this mean that advisors who are heavy into alts can expect heightened attention from SEC examiners in that area of their practice?

"I think that's pretty safe to say," Thompson says. "When they put a risk alert out, they're giving fair warning. It's sort of a shot over the bow. It's telling the advisory community we're interested in this. Make sure you do your compliance work in this area, because we'll probably be looking at it."

Kenneth Corbin is a Financial Planning contributing writer in Washington.