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The case for including some esoteric alternative investments in client portfolios is compelling: they can provide above-market returns that are not correlated to conventional investments and they allow a portion of wealth to be held in tangible assets that help mitigate the impact of inflation. However, as with all investments, there are some issues around recommending esoteric investments to clients.

Definition
To be clear, by esoteric investment I am not referring to any form of collective investment scheme or UCIS. I am referring to direct purchases of land or property or ‘real’ assets in the expectation that the purchase will bring investment benefits – perhaps by renting the land or property back to the investment provider to secure an income; renting it to a third party; selling the asset at a later date for a capital gain or perhaps simply by holding the asset as a store of wealth.

A large number of investments have been structured in this manner, with the returns and exits already built into the contracts, but they are technically still direct purchases of tangible assets, not financial instruments, and therefore they are not regulated by the FSA. This is one of the grey areas that make advisers apprehensive about making recommendations.

Where does responsibility lie?

Who is responsible for ensuring these products are suitable for the consumers who invest in them? Well, the FSA’s expectation is that IFAs will be giving advice and making sure they are only recommending products that are suitable for their clients.

There are workarounds – some IFAs choose to let clients make non-advised, execution-only investments into these products and some IFAs refer clients who are interested in esoterics to other businesses, but the bottom line is that when an IFA is involved, in all likelihood the buck will stop with them if it all goes wrong and the client seeks redress. After all, it may well be that clients’ expectations – and that of the FSA – are that advisers ‘advise’.

This can be a frustrating issue for IFAs because as non-regulated investments, esoterics can be sold by just about anybody – and non-IFAs have no obligation to be concerned about suitability. In a recent conversation with an IFA and a regulatory lawyer on this topic, the lawyer expressed the issue very clearly: when it comes to recommending esoteric investments, it is easier to be a milkman doing it as a side-line than it is to be an IFA looking to offer something new to their clients.

SIPP provider responsibility

A lot of esoteric investments are held within SIPPs and there have been moves by the FSA to try and put pressure on SIPP providers to do more due diligence to understand more about the nature of these investments. This is because, in some instances, SIPP providers are the only link in the chain that the FSA can influence.

Investors are introduced to non-regulated products by non-regulated introducers and they make non-regulated purchases of non-regulated assets: the SIPP provider is the one regulated entity where the FSA can apply some oversight. So there is now an expectation that they will, at the very least, carry out a ‘sniff test’ on investments they allow to be held.

However, this does not really extend to questions of individual client suitability and it probably never can do – SIPP providers do not have those kinds of relationships with their clients.

So if clients come to esoterics via an IFA, the expectation is that the IFA will either have ensured the client is suitable for this type of asset (and selected an esoteric product that meets their attitude to risk and investment objectives) or, alternatively, will have made it very clear that this is not something they are advising the client upon and that, in this instance, their role is limited to being an introducer only.

Who is suitable?
So what sort of client can be considered to be suitable for esoteric investments? As a lot of esoteric investments have a similar structure to UCIS, a sensible precaution would be for advisers to treat them as only being suitable for the same narrow client population as UCIS: high net worth individuals or sophisticated investors covered by one of the exemptions set out in COBS 4.12 of the FSA handbook.

A higher risk approach for advisers would be that they are suitable for clients who already have a balanced portfolio of conventional assets and have built up a pension pot that is well on the way to meeting their objectives.

These types of clients may well be prepared to take on some additional risk in return for the extra diversification esoteric investments offer, the possibility of higher returns or defined returns, the benefits of owning tangible assets and the opportunity to dabble in something different that piques their interest.

Clients in this bracket have enough wealth to justify the cost of diversifying properly across a range of assets and have the resources to overcome an investment failure or poor returns from a section of their portfolio.

There is also a case to be made for clients who are in drawdown or thinking about going into drawdown who want the benefit of products with defined returns to boost the amount of income they can take from their pension at the same time as preserving or growing their capital.

Finally, you may well have insistent clients who are fed up with poor returns from conventional investments or who feel their investment pots are so small (especially when they consider what kind of income they will be able to purchase in retirement), that they have a strong desire to try something different. The desire to do so even outweighing the loss of protection benefits clients would have from the FSA, FOS and FSCS in the regulated space.

Investment experience
Advisers will have to decide for themselves which category of client they are happy recommending esoteric investments to but, as always, it will come down to knowing and understanding individual clients. What is their investment experience? What is their current financial situation? What are their financial objectives? What is their attitude to risk, tax situation, health, income, expected retirement date, and so on?

With this knowledge of their clients, advisers can take a view on whether esoteric investments will be suitable for an individual client and help them to find superior alternative investment opportunities.