Wall Street Potholes - Simon A. Lack - E-Book

Wall Street Potholes E-Book

Simon A. Lack

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Recognize Wall Street tactics for what they are, and make smarter decisions with your money Wall Street Potholes shares insights into the money management industry, revealing the shady practices that benefit the salesman far more than the client. Bestselling author Simon Lack brings together a team of experienced money managers to give you straight-from-the-source intel, and teach you how to recognize bad advice and when it's better to just walk away. Investors are rightly suspicious that many products are sold more because of the fees they generate than their appropriateness to the client's situation, and that's only the beginning. This book lays it all bare so you can walk into your next deal with your eyes wide open. You'll learn just how big the profit margin is on different products, and why Wall Street intentionally makes things as complicated as possible. You'll learn expert tactics for combatting these practices, so you can avoid buying overpriced products and confidently discriminate against advisors who put their own interests first. For all the volumes of investment advice on the market, dissatisfaction with the financial services industry has never been higher. This book describes the reason for that disconnect, and tells you how to see through the smoke and mirrors to make the best decisions for your money. * Discover the profit margin built into some popular products * Learn the reason behind bundling and why Wall Street fears comparison shopping * Consider the importance of benchmarking, and why so many firms avoid it * Become better informed so you can easily recognize poor investment advice If asking questions of your financial advisor only nets more confusion, if you want to have more control over your money, you need a firm grasp of how these firms manipulate your trust. Wall Street Potholes tells you what you need to know to become a smarter investor.

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Table of Contents

Title Page





Chapter 1: Non-traded REITs: A Security That Shouldn't Exist

Poor Advice

Why Not Get a Listing?

Disingenuous Advice

Whose Side Is Your Financial Advisor On?

Where Are the Regulators?

Overall Returns Are Poor

The Importance of Benchmarking

Puts and Calls

Financial Advisors Need to Do Better

Chapter 2: Why Investors Pay Too Much for Yield

The Mysteries of Closed-End Funds

Investors Can Overpay to Simplify Their Taxes

The HFT Tax

When Managers Run a Company for Themselves

The Ham Sandwich Test

If the Prospectus Says You'll Be Ripped Off, It Must Be Legal

Timing Is Everything

Chapter 3: Why Structured Notes Are Rarely the Best Choice

Caveat Emptor!

Structured Note Basics

Why Buy Structured Notes?

The Heart of the Matter: The Arguments Against

Chapter 4: Update to The Hedge Fund Mirage

Hedge Funds Remain a Great Business

Industry Reaction to the Dismal Truth

Why Hedge Funds Are Still Growing

Some Accounting Rules Are Dumb

Politics Drives Asset Flows

Too Much Capital

For Once, the Retail Investor Wasn't Duped

Chapter 5: Why Is Wall Street So Inefficient?

Why Is Finance So Expensive?

Trading Doesn't Build a Secure Retirement

Invest Time before Money

Sex and Investing

Complexity Sells

The Hidden Costs of Municipal Bonds

Some Bankers Just Don't Think

Chapter 6: The Un-Portfolio and Better Portfolio Management Techniques


Un-Portfolios and Diversification

Fees and the Black-Box Models

Other Examples of Un-Portfolios

Exchange-Traded Funds

Mutual Funds and Fees

Load Funds

Fiduciary Duty

Portfolio Management Basics

Summary and Conclusion

Bonus Section

Chapter 7: Annuities


What Is an Annuity?

What Are the Different Types of Annuities?

Variable Annuities

Associated Risks

Other Risks Are Lack of Flexibility

Variable Annuity Riders

Illiquidity, or the Lack of Being Able to Get to Your Money

Evaluation of Returns: Investment Options inside of Variable Annuities

Fee and Charges

Options If You Already Own an Annuity

When Should You Consider Using an Annuity?

Recent Developments with Annuities

Savings Bonds: Little-Known Good Deal

Chapter 8: Is the Most Important Professional in Your Life Even a Professional?

My Start as a Broker

Pressure to Generate Business

Why You Don't Invest with Borrowed Money

Has the Industry Made Any Progress?

Is Financial Advisory a Profession?

Why You Want a Fiduciary

More Things to Consider When You Choose Your Advisor

A Better Way to Measure Results

Chapter 9: Putting Investors First

The Future of Finance

Understand Who Your Advisor Works For

Really Understand the Fees

Try Asking These Questions

What Else Can Be Done?

The Role of CFA Institute

Bigger Isn't Always Better

About the Contributors

About the Author



End User License Agreement





















































































































































































































































Table of Contents

Begin Reading

Wall Street Potholes

Insights from Top Money Managers on Avoiding Dangerous Products

Simon Lack


Copyright © 2016 by Simon Lack. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002.

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data

Lack, Simon, 1962- author.

Wall Street potholes : insights from top money managers on avoiding dangerous products / Simon Lack.

pages cm

Includes bibliographical references and index.

ISBN 978-1-119-09327-5 (cloth)— ISBN 978-1-119-09329-9 (ePDF)— ISBN 978-1-119-09325-1 (epub)

1. Investments. 2. Portfolio management. 3. Finance, Personal. I. Title.

HG4521.L25 2016

332.6— dc23


Cover Design: Wiley

Cover Image: © iStock.com/Mlenny

This book is dedicated to the anonymous retail investor trying to navigate a complex financial world.


Financiers were never especially well liked prior to the financial crisis of 2008. The bank bailouts compounded a general belief that bankers always make money regardless of the outcomes for their clients. This popular view had never sat easily with me as one who had made his career first in London and then on Wall Street. Although there were inevitably bad actors, I clung to the idea that part of the reputational challenge was the result of poor understanding by the general public.

Then I met Penelope, as described in Chapter 1, and was prompted to learn about non-traded REITs (real estate investment trusts), a murky corner of the securities markets that can only damage the reputation of anybody involved in the sale of these instruments to the general public. The fees, conflicts of interest, disingenuous marketing, and more fees were breathtaking. That it was all legal, because of its disclosure via a thick, densely written prospectus, was astonishing.

Discussions with industry colleagues found like-minded practitioners with their own examples of shoddy, self-interested advice provided to trusting clients. It soon became clear that a collection of advice from people on the inside would fill a needed gap in the education available to people simply trying to save for retirement.

The CFA Institute's efforts to shape the “Future of Finance,” and especially the Putting Investors First initiative, provided further impetus to promote better outcomes by warning against the wrong types of advice and products. Too often, the financial salesperson's interests are placed well ahead of the client's.

It is with this goal in mind, of Putting Investors First and thereby aiding better outcomes, that the five authors of this book have come together. The few we may offend are far less important than the many we hope to help.


Inspiration for this book came from my contributing authors Kevin Brolley, John Burke, Bob Centrella, and David Pasi. We all share a common vision that investing should be simpler, cheaper, and devoid of fee-laden traps. Further encouragement was provided by many other finance professionals, including Rich Covington and Tony Loviscek.

In my career I have had the good fortune to work repeatedly for people in banking for whom integrity was priceless, notably Don Layton, Don Wilson III, David Puth, and Jeffery Larsen. They represent the best of finance and what I still believe is the vast majority of financiers, notwithstanding the visible transgressions of some. Their values became mine.

The CFA Institute with its “Future of Finance” initiative, including Putting Investors First, promotes financial ethics as a cornerstone of investment competence, providing an institutional confirmation of the importance of doing the right thing.

The wonderful editing staff at John Wiley once again both shared our vision on an important topic and immeasurably improved the final result.

Chapter 1Non-traded REITs: A Security That Shouldn't Exist

Poor Advice

“I'm afraid you've been poorly advised,” I told the new client as she sat in my office. That was certainly an understatement—in fact, she'd been ripped off by the advisor at the brokerage firm that invested her money.

We had just finished reviewing the investments in her portfolio, which she had brought to me out of dissatisfaction with her existing advisor. It was a familiar discussion for me. I have worked in finance my entire life, mostly in New York, but early in my career I was in London. Since 2009 I've run my own investment business helping clients from individuals to institutions invest their money. The 23 years I spent at JPMorgan and the banks that preceded its many mergers was great preparation. During that time, I managed derivatives trading through enormous growth and at times high volatility; oversaw traders handling risks across multiple products and currencies; and more recently, led a business that helped new hedge funds get off the ground. I had seen Wall Street and “The City” (London's financial district) from the inside. It had been a great career, but by 2009, I was ready for a new challenge. The daily commute was increasingly a mind-numbing grind, and big financial companies were likely to face ever-greater constraints on their activities. The politics of financial reform understandably reflected public abhorrence at the required level of support from the US government following the 2008 financial crisis.

I was and remain very proud of my career at JPMorgan. The company emerged from 2008 in better shape than any of its peers. While it's true that it has had to concede substantial settlements to regulators since then, it's impossible for any big company to be immune from poor decisions or bad behavior somewhere in its ranks. The culture and the people with whom I worked overwhelmingly reflected the best in terms of values and integrity.

So I'd left the huge company where I'd spent almost my entire adult life to run something far smaller but also completely devoid of bureaucracy. My firm would reflect the values of the best people I'd worked with over the years as it sought attractive long-term investments in a format that treated clients' money as if it was mine. Many firms, and many people, do the same thing. But as I've found out since 2009, they don't all do the right thing. There's plenty of room for improvement in the quality of financial advice that is given to investors.

We all have to trust professionals when we need help with something that is not what we do for a living, whether it's medical treatment, legal advice, or auto repair. We generally buy products and services with the knowledge of an amateur, and we are often vulnerable to an unscrupulous provider. We look for honesty; when we don't find it, sometimes we discover in time to protect ourselves and sometimes we don't.

The world of investment advice can be dauntingly confusing. Saving for retirement is increasingly the responsibility of the individual, as defined benefit pension plans are phased out in favor of defined contribution plans, 401(k)s, and IRAs. Unless you're a public-sector employee where pensions are still based on your salary just prior to retirement, the money you have when you stop working will largely be the result of decisions you made (or failed to make) during your decades in the work force.

My client, whom we'll call Penelope (not her real name), sat across from me waiting for an explanation as to precisely what poor advice she had received. She was here with her husband, and we had met through a mutual friend. Like many investors, Penelope and her husband are smart people who have enjoyed professional success without having to understand the intricacies of investment products. Penelope is in the pharmaceutical industry (not uncommon in New Jersey) and her husband works for an information technology company.

Penelope had bought into a very common investment called a Real Estate Investment Trust (REIT). REITs typically own income-generating commercial property, including office buildings, warehouses, shopping centers, rental apartments, and so on. They can be a great way for individuals to own real estate managed by a professional company. Many REITs are publicly traded, allowing investors to sell their holding at the market price, and there are mutual funds and exchange traded funds (ETFs) that provide exposure to REITs. Used properly, they can be a legitimate component of an investor's portfolio providing income and some protection against inflation.

However, not all REITs are good, and a particular class of them called “non-traded REITs” is generally to be avoided. Penelope had unwittingly invested some of her savings in the wrong kind of REIT, one that provides substantial guaranteed fees to the broker selling it while often generating disappointing returns for the investor.

Public securities are registered with the SEC under the 1940 Investment Company Act. Registering a security requires the company to meet various tests for accounting standards, transparency, and so on. The advantage of registering is that the security can be sold to the general public. Unregistered securities have a far more restricted set of potential buyers. The investors have to be “sophisticated” (meaning wealthy, in this case), and the seller of such securities has to adopt a targeted marketing approach, going directly to people he thinks may be interested. You won't often see an unregistered security advertised, because the laws are designed to prevent that.

Hedge funds are another example of an unregistered security. Their sale is restricted to “sophisticated” investors deemed able to carry out their own research. It's a sensible way to divide up the world of available investments. Retail investors are offered securities that are registered and usually those securities are publicly traded, enabling the investor to sell if they wish. Sophisticated investors including high-net-worth individuals and institutions don't need the same type of investor protection, which allows them to consider unregistered investments that have higher return potential and also higher risk.

Non-traded (also known as unlisted) registered REITs fall in between these two classes of investment. By being registered, they are available to be sold to the general public. Having gone to the effort of registering, it's a reasonable question to ask why they don't also seek a public listing. It would clearly seem to be in the interests of the investors to have the liquidity of a public market listing so that they can choose to sell in the future. In fact, non-traded REITs have highly limited liquidity and often none at all. They can only be sold back to the issuing REIT itself, and the REIT is under no obligation to make any offer to repurchase its shares. They are a hybrid security—no public market liquidity and yet available to be sold to the public.

Generally, companies that need to raise capital, whether equity or debt, desire liquid markets in which to issue their securities. Liquid markets are widely believed to reduce a company's cost of finance. This is because investors require an illiquidity premium, or higher return, if they have limited opportunities to sell. Private equity investors expect to earn a higher return than if they had invested their capital in public equity markets. Small-cap stocks similarly need to generate higher returns than large-cap stocks to compensate for their more limited liquidity.

Although monthly income is the main selling point, the illiquidity can mean that your holding period exceeds the lease term on the properties. For example, if the non-traded REIT in which you're invested has five-year leases on its properties but you hold the investment for ten years, you have much more at risk than just your exposure to the monthly income.

Bond issuers care a great deal about the liquidity in the bonds they issue, and the selection of bond underwriter is based in part on the firm's commitment and ability to subsequently act as market maker after the bonds are issued. The ability to sell bonds at a later date induces buyers to accept a lower yield than they would otherwise, thereby reducing the bond issuer's interest cost.

To cite a third example, the justification for high-frequency traders (HFTs) with their lightning-fast algorithms in the equity markets is that their activities improve liquidity. Michael Lewis in Flash Boys provided a fascinating perspective on how HFT firms have been able to extract substantial profits from investors through using their speed to front run orders. I'm not going to examine HFT firms here, but suffice it to say that their existence reflects the overwhelming public interest in the most liquid capital markets possible.

Why Not Get a Listing?

So now we return to non-traded REITs, and consider why a company that is qualified to seek a public listing because its securities are registered nonetheless chooses not to. Generally, you want to raise money at the cheapest possible cost, so why do these companies deliberately operate in a way that raises their cost of financing?

I think the answer is, they don't wish to attract any Wall Street research. Brokerage firms routinely publish research on stocks and bonds, and they look to get paid for their research through commissions. Good research gets investors to act on it, and the commissions generated by this activity are what pay for the analysts. Companies want positive research because it will push up their stock price, making the owners richer as well as making it easier to raise more money later on.

But suppose you run a company that is designed primarily to enrich the sponsors at the expense of the buyers? What if you know that drawing the interest of research analysts is likely to result in reports that are critical of fees charged to investors and the conflicts of interest in your business model? Then you would conclude that the higher cost of financing caused by the absence of a public listing is a reasonable price to pay for the higher fees you can charge away from the glare of investment research. Because if there's no public listing, there are no commissions to be earned from trading in the stock, and no commissions means there is little incentive to produce research coverage.

It is into this regulatory gap that the sponsors and underwriters of non-traded REITs have built their business. Illiquid securities are normally only sold to sophisticated investors, but since the securities are registered they can be sold to anybody. This means millions of unsophisticated investors can be induced to make investments that they'd be better off avoiding.

Inland American Real Estate Trust, Inc. (IAR) was the non-traded REIT that drew my attention to this sector. Penelope held an investment in the REIT that had been recommended by her broker at Ameriprise. Disclosure is a great defense. It turns out you can do some pretty egregious things to your clients if you tell them you'll do so in a document. IAR's prospectus discloses many of the unattractive features that characterize how they run their business. Because they are registered, their registration and many other documents are publicly available. They don't necessarily represent either the worst or the best of the sector, but they are one of the biggest non-traded REITs, so it's useful to examine their public filings.

For example, underwriting fees on the issuance consisted of a 7.5% “Selling Commission,” a 2.5% “Marketing Commission” and a further 0.5% “Due Diligence Expense Allowance,” adding up to a fairly stiff 10.5% of proceeds. But it didn't stop there. In some cleverly crafted prose, the document goes on to explain that “…our Business Manager has agreed to pay…expenses that exceed 15% of the gross offering proceeds.” In other words, up to 15% of the investor's money could be taken in fees.

The registration statement is full of tricky English language such as this. The entire document is 132,192 words, approximately twice the length of this book. It's absurd to think that any investor who's not employed in the industry will read and digest such a thing. The 15% in fees were disclosed around 20% of the way through the document, so in a legal sense the client was informed, but not in a way that represents a partnership between the advisor and the individual.

There are other little gems, too. The company will invest in property that will then be managed by an affiliate. So in other words, the sponsors of IAR will make money from managing the assets owned by IAR as well as for running IAR itself. “Management Fee” occurs 45 times throughout the document, and includes fees on the gross income (i.e., rent). There's also a 1% management fee on the assets. The investors do have to receive a 5% return first, but that return is “non-cumulative, non-compounded,” which means that if they didn't earn the 5% return for investors in one year, they don't have to make it up the next year in order to earn their management fee. There are fees of 2.5% to the business manager if they buy a controlling interest in a real estate business. There's also a 15% incentive fee, basically a profit share, after investors have earned 10% (although it's not on the excess profit over 10%, but on the whole profit). The simple word fee occurs 528 times.

There are 40 matches for “conflict of interest,” including most basically that the buildings owned by IAR will be managed by an affiliate of the sponsor with whom they do not have an arm's-length agreement. Said plainly, don't expect that the management of properties is done at a fair price, but be warned that it may be unfairly high.

Now, to be fair, whenever companies issue securities to the public they hire lawyers to construct documents whose purpose is to protect the company from the slightest possibility of being sued after the fact. Glance through the annual report (known as a 10K) of almost any company and you'll find a whole list of “risk factors” telling you why you might lose money on your investment. Even Warren Buffett's Berkshire Hathaway, as honest a company as you'll find, includes a list of risk factors in its 10K that seem fairly obvious, such as, “Deterioration of general economic conditions may significantly reduce our operating earnings and impair our ability to access capital markets at a reasonable cost.” You'd think any investor would be aware of this, but it's in there anyway just so they can say they warned you.

IAR mentions “risk factors” 44 times. It warns the investor that it is operating a “blind pool,” in that they don't yet know (at the time of the offering) what real estate assets they're going to buy. They go on to warn that there may be little or no liquidity for investors to sell (how true that turned out to be).

Another common problem with non-traded REITs is that the high dividends that attract investors may not be backed up by profits. Interest rates have been low now for years and are likely to remain historically low for a good while longer, as I wrote in my last book, Bonds Are Not Forever: The Crisis Facing Fixed Income Investors. Low rates benefit people and governments who have borrowed too much, which applies widely in the United States as well as other countries. The low yields on bonds mean investors are starved of opportunities to earn a reliable, fair return with relatively low risk.

Non-traded REITs are sold because of their high dividend yields. However, there's no requirement that the dividends they pay are backed up by profits. They can simply be paid out of capital. This issue isn't limited to REITs, of course. Any company can pay out dividends in excess of its profits, at least for a while. Many companies follow a policy of paying stable dividends even while their profits fluctuate, recognizing the value investors place on such stability. As long as their profits are sufficient to pay dividends and reinvest back in their business for growth over the long term, paying dividends in excess of profits in the short run may not do any harm.

But non-traded REITs can pay a dividend that's higher than they can sustain even in the long run. It's like having a savings account that pays 2%, taking out 3% of it every year, and calling it a dividend. Part of the dividend is your own money coming back to you. Calling it a dividend misleads investors into thinking it's from money earned, which it's not. On top of that, non-traded REITs can often invest in properties that pay high rent but depreciate. An example might be a drug store such as Walgreen's, which could hold a ten-year lease on a property that has no obvious alternative tenants should Walgreen's decide not to renew the lease at its termination. It will pay above-market rent to compensate the building owner (i.e., the REIT) for the possibility that in ten years the building will have to be expensively reconfigured or even torn down in order to find a new tenant. As such, the building may well depreciate during the term of the lease, given the specialized nature of its construction. The depreciation often won't show up in the REIT's financials, leading to a delayed day of reckoning.

In fact, non-traded REITs are notorious for maintaining an unrealistically stable net asset value (NAV). They simply don't update the value of their holdings, and because their securities are not traded there's no way for investors to know if the value of their holding has fluctuated.

Disingenuous Advice

Some advocates of the sector, with utterly no shame, argue that the absence of a public market is a good thing. Sameer Jain, chief economist and managing director of American Realty Capital and someone who really ought to know better, praises “illiquidity that favors the long-term investor” (Jain 2013) as a benefit. Sameer Jain surely must know that illiquidity never favors any investor, long term or otherwise. This is why illiquid investments always require an illiquidity premium, a higher return than their more liquid cousins, to appropriately reward investors for the greater risk they're taking. Inability to sell what you own is never a good thing. He adds that non-traded REITs are “not subject to public market volatility,” as if that's a further benefit. That's like arguing that closing the stock market is good for investors so they can't see their investments fluctuate. Sameer Jain is a graduate of both Massachusetts Institute of Technology (MIT) and Harvard University, so I know he must be smarter than these statements make him sound. If you don't want to know what your portfolio's worth, don't look! In any case, as long as you haven't borrowed money to invest (rarely a smart move), fluctuating prices need not compel you to do anything you'd rather not do. Looking at an old valuation that's wrong and not updated should not provide comfort to anyone. It's head-in-the-sand, ostrich investing.

For example, in July, 2014 Strategic Realty Trust, another non-traded REIT, reduced the valuation of their REIT by 29% (InvestmentNews 2014), from $10 per share to $7.11. The previous $10 value had remained unchanged since it was launched in August 2009, at what should have been a great time to be investing in anything. It's doubtful any of the hapless investors in Strategic Realty would agree with Sameer Jain that five years of no reported changes in valuation had been helpful.

The reality is that the value of the underlying assets fluctuates depending on the economy, shifts in demand for real estate, location of properties, competition, successful retention of tenants and other reasons. Failing to change the NAV of the security in no way shields investors from their exposure to all these factors, it simply shields them from the knowledge of how their investment's value may have shifted. Publicly traded REITs provide a market perspective on these factors every day through their fluctuating prices.

The true value of Strategic Realty Trust didn't suddenly fall by 29%; that move reflected the cumulative effect of not updating the value over the prior five years. This is why investors normally seek higher returns on illiquid investments, notwithstanding the sales pitch for NTRs.

The point of this is to show how much important information can be buried in the lengthy legal agreements that accompany almost any investment. The challenge for the investor is how to navigate this territory. Penelope's experience is emblematic of an all-too-common problem for individuals trying to invest their money. They often find themselves sitting down with someone who calls themselves a financial advisor, when really they're talking to a salesperson.

In fact, the illiquidity doesn't benefit the “long-term investor” as Sameer Jain misleadingly asserts, but the issuer. For it turns out that, if you want to sell your regrettable investment in a non-traded REIT, without a stock market listing the only realistic buyer is the NTR itself. Persuading investors that they should prefer illiquid securities, and then being positioned to be the only plausible buyer when a hapless investor wants out is the essence of the sales pitch described above.

Penelope made this investment on the recommendation of the person who covered her at Ameriprise, a large brokerage firm (known as a broker-dealer from a regulatory perspective). Ameriprise, like other large brokerage firms, calls the people who deal with clients financial advisors. It's true they provide financial advice to Penelope and millions of others, but it doesn't mean they have a legal obligation to put their clients' interests first. The US regulatory structure recognizes two types of firm facing investors—broker-dealers and investment advisory firms. The difference is a subtle one, especially because many big firms operate as both. Broker-dealers generally charge commissions on trades you do, or in the case of bonds charge a price mark-up if they're selling you a bond they already own. Investment advisors charge a fee for their advice. The crucial difference is the broker profits when you do a transaction. They earn a commission, or a mark-up (or sometimes both). This can present a conflict of interest, in that a transaction may not be good for the client but is always good for the broker. Brokers are not required by law to put the clients' interests first, whereas investment advisors have a legal, fiduciary obligation to put their clients' interests ahead of their own.

One of the confusing things is that a broker can employ people it calls financial advisors, but they are not the same as investment advisors, a term that's legally defined to mean someone advising you as a fiduciary.

Who on earth wants to study the intricacies of US financial regulations? People just want access to honest advice. Calling someone a financial advisor places them in the same category as a doctor or lawyer, two professions that have a legal obligation to put the interests of their client (or patient) first. It's a bit like calling a car salesperson a transport advisor, or a real estate broker a housing advisor. Both will provide you advice, and the recipient of that advice will assess it with the knowledge that it's proffered by someone whose objectives are different than your own. There's nothing wrong with that as long as you know what type of relationship you're getting into.

I should at this point note that many financial advisors at brokerage firms are honest people truly putting the interests of their clients first. I have friends who do just that, and I'm not trying to criticize a whole industry. But they're not all good, and the bad ones create a problem for their clients as well as for the rest of us.

Some feel it would make a lot of sense for the people who work at brokerage firms and call themselves financial advisors to adopt a fiduciary standard, the same as investment advisors. (Yes, I know it's confusing. Financial advisors sound like investment advisors, but they're not.) If financial advisors had to meet a fiduciary standard it would make life far simpler for investors who choose not to become regulatory experts as they look for investment advice. But the brokerage industry recently lobbied successfully against such a move so it's unlikely to happen. I think that as long as a client understands their advisor's actual responsibilities they need not be a fiduciary.

Penelope misunderstood the type of relationship she had with her financial advisor at Ameriprise. Penelope thought she was dealing with someone who was required to consider her interests first and foremost (like a doctor or lawyer) whereas in fact she was dealing with the equivalent of a realtor, someone who would get paid out of the transaction fees extracted from Penelope.

This is where Inland American Real Estate Trust came in. The 10.5% of fees (and potentially up to 15%) that was to come out of the client's money the moment it was invested would typically be shared substantially with Penelope's “advisor.” So when Penelope was “advised” to make the investment, the advisor clearly had a conflict of interest. It's no different than a doctor prescribing medication to a patient and receiving a payment from the drug company that provided it.

Whose Side Is Your Financial Advisor On?

Some people who call themselves financial advisors sit on your side of the table acting on your behalf. These are Registered Investment Advisors (RIAs). They act as your agent and they're legally obligated to put your interests before theirs. Other financial advisors sit across the table from you, and their interest in the client's well-being is similar to that of any other salesperson. They generally work for brokerage firms (as opposed to investment advisory firms). Yes, they want you to invest your money in something worthwhile, but they also earn a transaction-based fee so products with higher fees benefit this type of advisor and inaction rarely makes them any money.

Many if not most of the financial advisors who work for brokerage firms genuinely put the interests of their clients first. I have friends in the industry about whom I feel comfortable making this statement. And clients who invest through an RIA are charged an advisory fee as well as having to incur commissions on the investments they buy. This can make the use of a financial advisor who works for a brokerage firm appealing in that there are only commissions to be charged. However, I believe the potential for conflict of interest can represent a negative for the client. The protections for clients against being marketed a poor investment can be weak (which was why Penelope was persuaded to invest in the non-traded REIT). The brokerage industry successfully fought attempts to impose a fiduciary standard on their salespeople (who often refer to themselves as financial advisors) so the client is basically reliant on the quality of the person with whom they're dealing.

My own business is a Registered Investment Advisor (RIA) and I am an Investment Advisor Representative (IAR). I'm pretty comfortable that although we charge a fee to manage money, the commissions charged on transactions by the brokerage firms through which we trade are low enough to not make much difference. If you trade online and infrequently, you minimize transactions cost, taxes, and the irrational impulse to try and profit from short-term market moves. The RIA has an obligation to put the client's long-term interests first. The financial advisor at a brokerage firm may put your interests first if he's so moved, but he may not be legally obliged to. As long as his recommendations are suitable and appropriately disclosed, then he's fine. He'll be paid based on his revenue production, and that production is often driven by transaction volume rather than the size of the accounts on which he's providing advice.

So let's return to Penelope and the non-traded REIT, Inland American Real Estate Trust, which she unfortunately owned. It had no public market valuation and therefore no way for Penelope to sell her holding. It had performed very poorly since being initially launched, and the fees charged were shockingly high. In fact, even more surprising than the level of fees was the fact that they weren't actually illegal. You would think being charged 15% of your investment would trigger some kind of securities violation, but it does not. I guess if it's there in the documentation you're expected to have read it.

Nonetheless, I suggested to Penelope that she go back to Ameriprise, who had sold her this investment, and ask them to buy it back from her at the original price. She clearly had not understood what she was getting into, and in my opinion it should never have been sold to her. At first, Penelope was unwilling to do this. She felt the advisor she'd been dealing with was a nice person (albeit evidently not that good at providing financial advice), so Penelope decided to move on and hope that somewhere down the road the REIT might buy back her shares.

A few months later, Massachusetts announced a settlement with the same firm on the same security. William C. Galvin is the Secretary of the Commonwealth of Massachusetts. In this role, he often pursues financial firms for wrongdoing in his state. No doubt many of these firms think he's overly aggressive, but it seems to me he's protecting the citizens of the state he represents. In early 2013, Massachusetts announced a settlement with Ameriprise over the improper selling of Inland American securities, which included an $11 million fine. Although the security itself was clearly designed so as to generate healthy commissions to the brokers that sold it, Ameriprise was merely guilty of selling the REIT to investors who were deemed unsuitable in that they didn't meet the minimum income or wealth standards Ameriprise had set. In other words, some brokers at Ameriprise violated their own standards, a lesser sin than if those standards themselves had been too lax.

Nonetheless it illustrated the conflict of interest that can face financial advisors at a brokerage firm. They may want to sell a security to an investor because of the fees they'll generate, whereas if they were truly an investment advisor not paid on commissions and legally obliged to put the client first, they wouldn't be in that position.

When this news broke, I was able to persuade Penelope to submit an official letter of complaint to Ameriprise. The settlement in Massachusetts was due to a regulator who saw it as his mandate to aggressively protect the citizens of his state. The absence of a similar settlement in New Jersey didn't vindicate Ameriprise in that state; it could simply be that the New Jersey regulator hadn't pursued the company on the same issue.

Penelope hadn't understood the risks and costs of the investment when she'd made it, but it's pretty hard for an individual to achieve redress in such situations. The prospectus (all 132,192 words of it) had spelled out the risks and Penelope was assumed to have read it. Ameriprise declined to do anything. Soon after, a private equity fund offered to buy investors out at a 35% discount to the original offering price. Penelope reasonably enough decided to take the cash offered, and move on. Caveat emptor (“Buyer beware”) ought to be on every non-traded REIT prospectus.

Penelope had been poorly served by the financial advisor assigned to her account. While Penelope had treated the relationship as one in which she was receiving advice tailored to her best interests, in reality she was involved in a buyer/seller relationship with misaligned interests. Of course there's nothing necessarily wrong with buying something from a salesman. You just need to approach the relationship with the right perspective. Penelope treated the relationship with her financial advisor the same way she would with a doctor, assuming that the advice offered was devoid of any conflict of interest and was with her best interests first and foremost. Really, she was dealing with a used car salesman.

Where Are the Regulators?

At this stage, you might ask yourself, where are the regulators? If investors are being sold securities with ridiculously high fees and no liquidity, how come the government isn't doing something about it? There's certainly no shortage of laws and regulations that apply to finance. It is a highly regulated industry, and becoming more so every year. Fortunately, though, the Securities and Exchange Commission (SEC) is not responsible for offering a view on whether an investment is good or not. That's obviously as it should be. Reasonable people disagree all the time on the relative merits of one investment versus another. There's little benefit to the government having a view as well.

But the regulators can warn investors against certain types of investment. FINRA (the Financial Industry Regulatory Authority) has, to its credit, done this. Its website (FINRA 2012) offers warnings about the most adverse features of non-traded REITs, including the fees, lack of liquidity, and the fact that it operates as blind pools (you invest before any properties have been bought so you don't know what you'll own). The website notes that fees can be up to 15% of your invested capital (15% is the legal maximum—probably not coincidentally what Inland American set as its maximum).

FINRA's “Investor Alerts” section of its website includes warnings about several investments that should be approached with a high degree of skepticism, including certain types of annuity, structured notes, and some exchange-traded funds (ETFs). These and other pitfalls are all covered elsewhere in this book. I wasn't even aware of this website myself until I started looking for it—FINRA should find ways to publicize its existence, but it's not the kind of topic that's going to get TV producers lining up to book you on their business show. Nonetheless, at least the regulators are trying to do something to warn investors.

If a security is on FINRA's “Investor Alert” page, why would any self-respecting firm even get involved? Shouldn't that be enough to persuade firms that truly put the client first to stay away from such a security? I think that's part of the problem. Too few retail investors are aware of the warnings and potential problems. The brokerage firms involved like the fees and hardly ever find themselves in conversations explaining why they're selling something that, in effect, carries a government warning. It's why finance earns itself a poor reputation. Anybody who's bought a non-traded REIT and after regretting it subsequently found FINRA's website has every reason to be outraged at being offered the security in the first place. There's not enough good judgment being exercised. Maybe there ought to be a requirement that if you're recommending a security that is the subject of one of FINRA's Investor Alert pages, you have to provide a copy of the alert to the clients before they make a decision. Non-traded REITS' warning should be prominent, like that on cigarettes. The warning is already out there, just not well publicized. Doesn't the regulator want the retail investors they're charged with protecting to be aware of the dangers the regulator has identified? Isn't FINRA doing more than just expressing a research view?

I've chatted to some in the industry who disagree with me on non-traded REITs. One in particular thought my criticisms were unjustified and based on a poor understanding of the merits of the product. His argument relied on the fact that he'd had some very positive experiences for his clients with non-traded REITs, in that they'd made money. In other words, he'd found some that worked, so as long as you invested through someone like him possessing the insight to tell the wheat from the chaff, you'd be in good shape.

It's a common argument, and a weak one. First of all, just because some people have made money doesn't mean that on average they will. You can make the same case for casinos or the lottery. There are always some winners, but most gamblers understand that the odds are against them. These people gamble because the excitement of potentially winning overwhelms any understanding they may have of probability theory. Casino owners aren't poor, and publicly run lotteries augment tax revenues in many states. I avoid casinos and don't buy lottery tickets, but the people who do bet on lotteries save the rest of us from even higher taxes so they're performing a selfless public service.

Of course, using the fact of one good non-traded REIT as support for the overall investment sector isn't exactly careful research, any more than the bells ringing on a slot machine should persuade you to sit down with a bucket full of tokens. The correct question is, how have non-traded REITs done in aggregate? It turns out there's no reliable answer to this question. There's no non-traded REIT index. For the brokers who make fees selling them, such an index would probably hurt business. They certainly wouldn't want clients who knew enough to ask for the returns on such an index—the less sophisticated the better. And the existence of an index would also allow the performance on a specific non-traded REIT to be compared against its peers, revealing whether the profitable return was simply a result of a good market for similar securities rather than value-added security selection by the broker.

Overall Returns Are Poor

There is a 2012 study (Reuters 2014) by Blue Vault Partners and the University of Texas that analyzed the start-to-finish returns on 17 non-traded REITs. They found that the internal rate of return (a type of investment return that reflects inflows and outflows on multiple dates) was just over 10%. That sounds good, except that over the same time, publicly traded REITs performed 1% or so better.

Another study carried out by Securities Litigation and Consulting Group (Wall Street Journal 2014), a research company based in Fairfax, Virginia, compared 27 non-traded REITs that had gone through a full cycle from raising capital to returning the proceeds to investors. Their study covered a period of more than 20 years, from June 1990 to October 2013. They found that after fees investors earned 5.2%, compared with the Vanguard REIT Index Fund (a mutual fund) of 11.9%. So in exchange for no liquidity, higher fees, and generally fewer safeguards, investors earned a lower return. Private equity investors expect returns above those available in the public equity market, as compensation for the additional risks involved. An additional return of 3% to 5% is not an uncommon requirement, meaning that if a chosen equity index such as the Russell 2000 returns 10% during the time period that the private equity investor held his investments, he would expect to have earned 13% to 15% or more. Otherwise, the choice of private equity was not worth the risk compared to its more liquid publicly traded equivalent.