March 8, 2007
This letter is being written by the two principals of a registered investment advisory firm based upon 25 and 15 years of working with individual clients on a fee-only basis. We believe that it is important that such clients either have personally or have access to a sufficient level of knowledge and financial sophistication from a fiduciary, in order to make informed investment decisions.
However, we disagree with the proposed rules revising the definition of an accredited investor. Our objection is on the following grounds:
1. the quantity of investment assets does not equal a level of knowledge,
2. the risks of private investments vary widely—how can one degree of protection apply to all?
3. the proposed rule does not address the amount an investor meeting the new standard might invest in private funds, hence not providing any benefit to their ability to bear the resultant economic risk,
4. all of the above issues can be better addressed by providing an exemption to those who engage a fiduciary to provide investment advice, and
5. the proposed rule removes a potential vehicle for those newly excluded from managing their investment portfolio risk and lowering investment costs.
The level of investment assets does not equal the level of investment knowledge. We agree than an appropriate objective is, as noted on page 17 (III A), only such persons who are capable of evaluating the merits and risks of an investment in private offerings may invest in one. However, as noted on page 18 (III A), natural persons may have indirect exposure to private pools as a result of their participation in pension plans. Such plans and vehicles are generally administrated by entities of plan fiduciaries and registered investment professionals. We believe that the better path, rather than relying upon an arbitrary amount for qualification, would be to encourage the investor to rely upon the judgment of an investment professional acting as a fiduciary for the investor.
In your definition of an Accredited Natural Person (page 20-21 III B 2) you note that your goal is providing an objective and clear standard to use in ascertaining whether a purchaseris likely to have sufficient knowledge and experienceor to hire someone who can. It does not take $2.5 million of investable assets to do so. Our client minimum investment, for which we charge 1% of assets, and that of many similar Registered Investment Advisers who are acting as fiduciary for our clients with discretionary authority, is $500,000—even below the current level for an accredited investor.
The responsibility for ascertaining that the investor has
The level of knowledge and financial sophistication, and
The ability to bear economic risk,
can be borne by the fiduciary at a reasonable cost with assets of one million, the current level of accreditation.
The amount of investment risk of private investments varies widely—a single rule does not seem appropriate for all private investments. We believe this can better be addressed by an investor and a fiduciary advisor on a portfolio-by-portfolio basis.
We compared the HFRI Equity Hedge Index, the HFRI Equity Market Neutral Index, the HFRI fund of hedge funds composite index and the SP 500 index.
Over 2, 3, 5 and 10 years, the SP 500 Index (an investment allowed to any investor) was the most volatile (in terms of Annualized Standard Deviation 6.9, 6.9, 12.4 and 15.4% respectively and Maximum Draw-down -4.0, -4.0, -28.4 and -44.7%)
Over the same time periods the HFRI Market Neutral Index (which an index of hedge funds primarily available only through private vehicles) is the least volatile (Annualized Standard Deviation 1.7, 1.9, 1.9 and 3.8% respectively and Maximum Draw-down -0.6, -1.2, -1.2 and -3.9%)
The HFRI Equity Hedge Index (another typical hedge fund index) has 10.2% standard deviation and -12.8% draw-down over 10 years – much less than traditional stocks as represented by the SP 500 Index.
The HFRI Fund of Funds index (a blend of hedge fund styles) has a standard deviation of 5.0% and maximum draw-down of -9.2% over 10 years – again not as risky as the unsophisticated might assume.
The proposed change to the level of accreditation does not prevent inappropriate amounts being invested by investors who have met the hurdle of $2.5 million of investable assets. The only way the issue of appropriate allocation to private investments can be addressed, in our opinion, is by holding a fiduciary/registered investment advisor responsible for advising the investor as to the appropriate amount. No limits will do this, only divorcing the recommendation from sales compensation and holding the advisor accountable can provide commonality of interest.
Changing the accreditation standard as proposed removes a potentially useful investment vehicle from those with net worth greater than $1 million per family and investment assets less than $2.5 million per person.
During times of market distress, private assets have proven more stable in valuation—less subject to hysteria-induced valuation swings.
Non-correlated assets are often available at a reasonable cost only through private vehicles. This change will reduce competition by reducing the opportunities to investors in this gap.
Investments which are less liquid, like natural resource investments which are only available through private vehicles, give the investor the opportunity to diversify their overall portfolio. These investors will lose the ability to diversify into such investments as:
o Individual real estate projects
o Oil and gas production
o Managed futures (both long and short)
These investors will lose their ability to reduce investment costs by using private pools of marketable common stocks, instead of higher-cost mutual funds, by avoiding:
o Shareholder service fees
o 12b1 fees
o Shelf space fees charged to funds by fund supermarkets such as Schwab and Fidelity.
In summary, we recommend that for investors utilizing a fiduciary advisor, such as a registered investment advisor, allowing the $1 million standard for accreditation to stand, raising it only for those without such an advisor.
John W. Ueleke, President and Chief Executive Officer
Richard R. Vosburg, Chief Investment Officer
Legacy Wealth Management, Inc.
6800 Poplar Avenue, Suite 101
Memphis, TN 38138