In my time studying for the Chartered Financial Analyst exams, one of the topics that came up over and over again was the importance of due diligence. Due diligence is “the investigation into the details of a potential investment, including the scrutiny of operations management and the verification of material facts.” As we face a richly valued stock market, it seems more and more investors are interested in turning to alternative investments to stretch returns, but one of the risks of utilizing alternatives is failing to do your due diligence.
In the study material on alternative investments, the CFA Institute notes that alternatives have a high due diligence cost as a result of complex investment structures and strategies, evaluations based heavily on business-specific and asset-specific expertise, and reporting that lacks transparency. Indeed, when you consider how unique some alternative investments can be, it’s difficult to ascertain whether their business fundamentals are healthy and whether the economic environment lends to their success. This should cause us to be incredibly cautious when considering alternative investments especially when they’re being pushed by a broker or adviser with little to show for their due diligence. In order to hold them accountable when it comes to these types of investments, consider asking them some of the following questions:
1.) What is the liquidity like?
Typically alternative investments are highly illiquid (in fact, illiquidity is one of the characteristics used to qualify something as an alternative). This is because, unlike a major corporation that’s already generating revenue, alternatives are usually comprised of riskier business ventures – things like real estate projects and startups which take longer to get going and therefore take longer to make you money. Don’t be afraid to push for a concise answer. Ask questions like “what is the timeline for the project” and “is that realistic” or “are there potential obstacles that could slow things down?” If you need easy access to cash an illiquid investment is probably not a good idea.
2.) What are the relevant risks?
Alternative investments have a different risk profile from traditional investments and it’s important to take that into account. Just because something is a “special investment” or something you “can’t get in the financial markets” doesn’t make it less risky. Sometimes it makes it even riskier. This doesn’t mean that investments like small-cap or real estate can’t be done well. It just means that you need to do your due diligence and understand what the relevant risks are and ask yourself if those are risks you’re willing to take. Small companies can have huge return potential but they also have a huge potential to fail. For every successful tech startup, there have been dozens that didn’t make it. Whenever I read an article about an exciting new company in the energy or commodities sectors, I email it to my husband who is a Ph.D. candidate in metallurgy and ask him to explain to me if what they’re doing really is cutting edge and economically feasible or if it just sounds that way.
3.) Is there a conflict of interest?
With any investment opportunity, I think it’s healthy to be skeptical. I assume all opportunities are bad until proven otherwise. One of the reasons I think this is a good idea is because everyone has an agenda. That’s not necessarily a bad thing, it’s just typically the truth and I think it’s OK to ask what that is. I want to know that whoever is selling me this investment has done their due diligence as well and isn’t just peddling a friend’s company because they’ve been offered a nice kickback.
As an investment professional, I take what I do very seriously and I believe a big part of doing it well is doing my due diligence. I am fortunate enough to work alongside a team that believes the same. If you’d like to learn more about how we invest and what we believe I invite you to take a look at some of our other articles or give us a call.
Institute, CFA. 2016 CFA Level III Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives. CFA Institute, 07/2015. VitalBook file.