(AssetMark) Clients want to rely on a financial advisor to make the best investment decisions for their future. As a financial advisor, the many options available can make it challenging to determine which products, services, and vendors best fit your clients' needs.
That's where due diligence comes in. By conducting thorough research on investment opportunities and strategies, you can offer your clients a diverse range of solutions to help them achieve their financial goals.
In this fast-paced industry, due diligence is not only essential, but also provides you with a competitive advantage. So, let's explore why financial advisors must prioritize examining their options and careful valuation in their practice.
In this article, we'll explore the different types of due diligence financial advisors should conduct, including investment due diligence, vendor due diligence, and client due diligence. We'll also provide a checklist of must-haves for investment due diligence, discuss common mistakes to avoid, and provide tips for communicating your findings to clients. Finally, we'll highlight some useful tools and resources for staying up to date with regulatory requirements for financial advisors.
What is Due Diligence for Financial Advisors?
Due diligence for financial advisors is a process of conducting a thorough investigation and analysis of potential investments, products, or services on behalf of clients. The goal of due diligence is to gather all relevant information, assess the risks and benefits, and make informed decisions.
Due diligence involves examining a variety of factors such as the financial stability of the organization, the experience and track record of the management team, regulatory compliance, market conditions, and potential risks.
Financial advisors must ensure that they have completed the necessary due diligence before engaging with a third-party service provider or recommending any investment to their clients, as it helps to protect their clients' investments and maintain their trust.
The Importance of Investment Due Diligence for Financial Advisors
Conducting due diligence is a critical aspect of the investment decision-making process for financial advisors. Here are some reasons why due diligence is critical:
- Mitigate Risks
Conducting due diligence helps to identify potential risks associated with an investment opportunity. By analyzing publicly available materials, including the financial data, legal documents, and interviews with investment managers, and other relevant information, financial advisors can identify any potential risks that may impact the investment decision to select a specific investment solution. This analysis helps to mitigate risks and protect client investments. - Make Informed Investment Decisions
Due diligence provides financial advisors with the data to have a comprehensive understanding of the investment solution and making an informed decision on whether it opportunity. Analyzing financial statements, legal documents, and other relevant information, can facilitate an informed investment recommendation that aligns with their clients' investment goals and risk tolerance. But it shouldn’t stop at the point of decision, a key aspect of due diligence should be the ongoing monitoring. It’s important to make sure the investment thesis still holds and that financial advisors’ recommended selections are still relevant. - Enhance Client Trust
Conducting due diligence demonstrates a financial advisor's commitment to their clients' financial well-being. By conducting a thorough analysis of investment opportunities, financial advisors can enhance their clients' trust and confidence in their investment recommendations. Advisors should also be proactive in communicating with their clients any changes. - Compliance Requirements
Financial advisors are required to conduct due diligence by regulatory bodies such as the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA). Failure to conduct due diligence could result in regulatory penalties or legal liability. - Improve Performance Expectations
Conducting due diligence is essential in helping financial advisors to set appropriate performance expectation with their clients, by identifying potential risks and opportunities associated with an investment opportunity.
By analyzing financial data, the strategy’s process, portfolio construction, and risk management, financial advisors better understand the performance traits of the investment
solution in different market trends. This allows financial advisors to appropriately select the investment solution for their client’s goals and risk profiles. With ongoing monitoring, financial advisors can make informed investment decisions that can lead to improved investment performance.
In summary, conducting due diligence is a critical aspect of the investment decision-making process for financial advisors. It helps to mitigate risks, make informed investment decisions, enhance client trust, comply with regulatory requirements, and improve investment performance expectations.
What Are the Different Areas that Require Due Diligence?
Due diligence process is a broad category that can mean different things at different times. Often, a primary part of due diligence includes uncovering financial information and looking for any red flags that might point to increased risk. The types of due diligence needed are typically influenced by the types of businesses involved. It’s crucial that every part of your business and offerings are trustworthy.
Here are three areas where advisors should carefully practice due diligence: investments, vendors, and clients.
1. Investments
Financial advisors investing clients’ assets in any investment vehicle—whether it be individual stocks and bonds, mutual funds, ETFs or model strategies—should conduct due diligence to make sure the investment is viable and suitable for their client.
Researching the investment option should include a review of a wide range of information including financial statements, legal filings, management teams and more. For example, insurance companies that sell annuities should be researched to determine their credit ratings and financial health.
In the case of mutual funds, etfs and model strategies analysis needs to be completed on the investment team and organizational oversight, and more importantly on the investment processes and risk management to assess performance results. This helps determine whether the management team delivered on expectations.
Advisors conduct research into the stewards of a business to see if they are engaged and free from regulatory, ethical or legal issues. Due diligence helps an advisor proceed confidently to invest in or partner with companies that are solid from the top down.
2. Vendors or 3rd Party Service Providers
Financial advisors may work with vendors for services to provide comprehensive support for clients, such as portfolio management, custodial services, or market research. It is important for financial advisors to conduct due diligence on these third-party service providers to assess their financial stability, reputation, and ability to deliver services as promised.
Vendors could include cybersecurity firms, legal counsels, custodians, investment or compliance management. Ensuring these companies meet stringent ethical and financial standards protects both financial advisors and clients.
3. Clients
Rules surrounding the Know Your Customer (KYC) standard have been put in place to establish a customer's identity and identify any risk factors. Don’t assume people are who they say they are. Doing due diligence on your clients helps prevent identity theft, money laundering, financial fraud, terrorism financing, and other financial crimes.
Financial advisors must keep detailed records of their KYC procedures, including any information obtained from the client and any analyses performed. They must also periodically update this information and monitor their clients' accounts for suspicious activity.
It is essential for financial advisors to comply with KYC rules to prevent financial crime and protect their clients' interests. Failure to comply with KYC rules can result in regulatory penalties, fines, and damage to the advisor's reputation.
What Is the Difference Between Financial Due Diligence and Investment Due Diligence?
Financial due diligence and investment due diligence are both processes of analyzing and assessing investment opportunities, but they focus on different aspects of the investment.
Financial due diligence is primarily focused on evaluating the financial health and performance of a company. This includes analyzing financial statements, accounting records, tax documents, and other financial data to assess the company's financial stability, profitability, and potential risks. The goal of financial due diligence is to provide a comprehensive understanding of the financial situation of a company and identify any financial risks that may impact the investment decision.
On the other hand, investment due diligence is a broader process that encompasses a broader array of investment options and focuses on the viability of the investment and whether consistent disciplines have been used to achieve its performance results. It will incorporate financial due diligence but also includes other factors such as assessment of management teams, business governance and organizational structure, investment processes and risk management, and performance results of the investment along with market analysis and industry trends. The goal of investment due diligence is to provide a comprehensive evaluation of the investment opportunity as a whole, taking into account both financial and non-financial factors.
In summary, financial due diligence is a subset of investment due diligence that focuses specifically on evaluating the financial health and performance of a company or investment opportunity, while investment due diligence is a broader process that encompasses both financial and non-financial factors in assessing investments.
What Types of Information Are Uncovered in the Due Diligence Process?
The due diligence process can uncover a wide range of information, depending on the type of investment opportunity being evaluated. Some common types of information that may be uncovered during due diligence include:
- Financial information
Financial statements, tax returns, and other financial documents can provide insights into cash flow problems and the financial health and performance of the investment opportunity. - Legal and regulatory information
Information on any legal improprieties or regulatory issues, such as pending lawsuits or regulatory violations, can help assess the investment opportunity's legal and regulatory risks. - Operational information
Understanding the operations of the investment opportunity, including its supply chain, cybersecurity protocols, and their leadership structure can provide insights into its overall stability and potential for growth. - Market information
Analyzing market trends and the competitive landscape can help assess the investment opportunity's potential for success in its market. - Reputation and social responsibility
Evaluating the investment opportunity's reputation, customer complaints, and social responsibility, including its environmental, social, and governance (ESG) practices, can help assess the potential for long-term success and sustainability.
In the financial services industry, due diligence is conducted to protect the interests of both financial advisors and their clients by determining if the businesses and people entrusted with a client’s assets and personal information are secure, capable, and reliable.
How to Identify Red Flags During Due Diligence
Financial advisors must be vigilant when conducting due diligence and identify any potential red flags that could indicate a problem with the investment opportunity. Due diligence is an ongoing process not a one-time evaluation when adding a new investment. It’s critical to make sure the original investment thesis still holds over time and not just at a point in time.
Red flags may include inconsistencies in financial statements, a lack of transparency or disclosure, unexplainable performance history, regulatory violations, lack of independent oversight and conflicts of interest. Factors that could lead to a change in status include, but are not limited to, key personnel turnover, acquisitions, shift in investment philosophy or process, and unexplainable performance.
Financial advisors should also be wary of investment opportunities that promise high returns with little risk. By identifying red flags early on, financial advisors can avoid investing in unsuitable opportunities and protect their clients' interests.
The Role of Due Diligence in Managing Investment Risks
Due diligence plays a critical role in managing investment risks. By conducting thorough due diligence, financial advisors can identify potential risks associated with an investment opportunity and take steps to mitigate those risks. For example, if an investment opportunity is deemed to have a high level of risk, financial advisors may recommend a smaller investment allocation or suggest that the investment is not suitable for the client's risk tolerance. By managing investment risks through due diligence, financial advisors can help their clients achieve their investment objectives while minimizing potential losses.
What Are the Due Diligence Requirements for Financial Advisors?
Due diligence is a key part of an Investment Advisor Representatives’ (IARs’) fiduciary responsibility to act in the best interests of their clients. Additionally, all financial advisors have a vested interest in working with reliable vendors who will uphold their professional reputation as they execute duties on behalf of clients.
Regulatory Requirements
Financial advisors are subject to various regulatory requirements when it comes to due diligence. For example, the Securities and Exchange Commission (SEC) requires registered investment advisors to have policies and procedures in place to ensure they conduct adequate due diligence on investments and investment strategies. The Financial Industry Regulatory Authority (FINRA) has also issued guidance on client due diligence. Additionally, the Department of Labor (DOL) has fiduciary rules that require advisors to act in their clients' best interests and conduct thorough due diligence when selecting investment options for retirement plans.
It's important for financial advisors to stay up to date with these regulatory requirements and ensure they are following them in their due diligence process.
Proof of Due Diligence
Conducting due diligence isn’t enough. Financial advisors must be able to “show their work” and prove due diligence has been done. Maintaining records of your efforts and results—and the ability to produce those records if needed—is an important part of the legal due diligence process.
Ongoing Diligence
Due diligence is not a “one-and-done” requirement. It should be conducted regularly to ensure the standards put in place at the time of the initial review still apply. Set up a schedule for revisiting the due diligence process on a regular basis and not just after a significant event.
The due diligence process is good business. Beyond the regulatory requirements, clients need to know they are entrusting their assets to a financial advisor who has done their research.
2 Investment Due Diligence Checklist Must-Haves
Documentation is a critical part of the due diligence process. For a comprehensive process, your financial due diligence checklist should include these two well-documented steps across all the aforementioned areas that require due diligence.
1. Documentation of Your Due Diligence Process
For business continuity reasons and regulatory oversight, financial advisors must have written policies and procedures that dictate steps to conduct a thorough and appropriate due diligence process.
2. Records of Your Due Diligence Research
Financial advisors must maintain detailed records of their due diligence efforts, including research reports, financial statements, client profiles, and any other relevant documentation.
This documentation can serve as proof of the financial advisor's due diligence efforts in the event of a regulatory audit or legal action. Financial advisors must also ensure that their documentation is organized and up to date, making it easier to review and update as needed.
Financial advisors should check with their legal/compliance professionals to determine how long records should be kept.
Common Due Diligence Mistakes to Avoid as a Financial Advisor
There are several common mistakes that financial advisors should avoid when conducting due diligence:
- Failing to consider all relevant factors
- Failing to maintain documentation of the due diligence process
- Relying too heavily on a single source of information
- Neglecting to conduct ongoing monitoring
Financial advisors must also avoid conflicts of interest that could compromise their objectivity when evaluating investment opportunities. By avoiding these common due diligence mistakes, financial advisors can help to ensure that they make informed investment decisions in the best interests of their clients.
How to Communicate Due Diligence Findings to Clients
Financial advisors should be prepared to communicate due diligence findings to clients. This communication should be clear, concise, and transparent, ensuring that the client understands the risks and benefits associated with the investment opportunity.
Risks, potential returns, any potential red flags and any other relevant information, should be included. By communicating due diligence findings effectively, financial advisors can build trust with their clients and help them make informed investment decisions.
Staying Up-to-date with Regulatory Requirements for Due Diligence
Regulatory requirements for due diligence are constantly evolving, and financial advisors must stay up to date to ensure that they remain compliant. Financial advisors must be aware of the regulatory requirements in their jurisdiction, including any reporting requirements, disclosure requirements, and record-keeping requirements. They must also understand the consequences of non-compliance, including fines, legal action, and damage to their reputation.
Industry associations such as the Financial Planning Association (FPA) and the National Association of Personal Financial Advisors (NAPFA) provide educational resources, networking opportunities, and other resources to help financial advisors stay up to date on best practices and conduct due diligence effectively.
By staying up to date with regulatory requirements for due diligence, financial advisors can ensure that they operate ethically and responsibly.
Due Diligence Tools and Resources for Financial Advisors
There are several tools and resources available to financial advisors to help conduct due diligence effectively. These include online databases, research reports, financial statements, and other industry-specific resources.
- SEC EDGAR Database: The SEC EDGAR database provides access to public filings for publicly traded companies, which can be useful when conducting due diligence.
- Morningstar: Morningstar provides data and analysis on various investment options, including stocks, mutual funds, and exchange-traded funds (ETFs).
- Bloomberg Terminal: Bloomberg Terminal is a software platform that provides real-time financial data, news, and analytics, including information on stocks, bonds, and other investment options.
By utilizing these due diligence tools and resources, financial advisors can enhance their due diligence process and make informed investment decisions for their clients.
Remain Aware of Events Impacting Your Vendors
Sign up for a reporting service or set up a Google Alert for your third-party service providers. These can scour everything from news sites to LinkedIn and Twitter posts. This way, if news is released that may impact your relationship, you will be aware and can investigate immediately.
Investment Due Diligence at AssetMark
AssetMark’s award-winning (Most Influential Gatekeepers) due diligence team conducts ongoing due diligence on every third-party strategist on the platform using a thorough and detailed process. The team’s philosophy is centered across Five P’s:
- People Who is making the investment decisions and what’s their experience?
- Philosophy What are the grounding beliefs of the investment team?
- Process Is there discipline and structure to the investment process bringing consistency and repeatability over time?
- Portfolio construction How is risk defined, evaluated, and managed for?
- Performance Do returns provide the proof that the investment managers have delivered on expectations?
Our team of experienced due diligence professionals has knowledge, contacts and experience that goes beyond a database. The team’s extensive 5-step review includes a comprehensive evaluation and regular and ongoing meetings with investment managers.
The ongoing tiered daily, monthly, quarterly, and annual review processes include performance, attribution, and asset allocation change reviews, onsite visits and calls with portfolio managers, qualitative and quantitative evaluations, due diligence questionnaires, and more. The process followed by the team is thorough and overseen by a governance structure of investment committees to ensure all recommendations are relevant and we adhere to a repeatable disciplined process.
The results of the in-depth reviews and updates are published quarterly in factsheets to help advisors understand the strategy’s strengths, issues, and expected performance patterns. Any changes in status of investment managers are shared as they occur during the year in a published report.
AssetMark is a turnkey asset management platform committed to the due diligence process. AssetMark puts high-quality, thoroughly researched resources into the hands of financial advisors. This makes it possible to simplify areas of your business without compromising your fiduciary duties. Are you interested in learning more about AssetMark’s due diligence process or turnkey solutions? Talk to one of our team members today.
