Financial advisors have gotten an SEC warning: Take care when constructing client's portfolios with alternative investments.

In a risk alert issued Tuesday, the SEC's Office of Compliance Inspections and Examinations critiqued the due diligence processes that advisors use when recommending or placing clients' assets in alternative investments such as hedge funds, private equity funds, or funds of private funds.

"Money continues to flow into alternative investments," Drew Bowden, director of the SEC compliance unit, said in a statement. "We thought it was important to assess advisors' due diligence processes and to promote compliance with existing legal requirements, including the duty to ensure that such investments or recommendations are consistent with client objectives."

While SEC officials said advisors are seeking more information from the managers of alternative investment products, the agency also cited some deficiencies its staff had found in the course of examining several advisory firms. Among the advisor problems highlighted:

  • Omitting alternative investment due diligence policies and procedures from their annual reviews -- even though these investments made up a large portion of certain advisors' investments on behalf of clients.
  • Providing potentially misleading information in marketing materials about the scope and depth of due diligence conducted.
  • Having due diligence practices that differed from those described in the advisors' disclosures to clients.

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