Swedroe: Watch Out For Potholes

June 01, 2016

Simon Lack’s first book, “The Hedge Fund Mirage: The Illusion of Big Money and Why It's Too Good to Be True,” chronicles the history of the hedge fund, highlighting many subtle and not-so-subtle ways that risks and returns are biased in favor of the fund manager.

He shows that, while it is certainly true that hedge funds have produced some of the greatest fortunes in recent years, the shocking reality is that while hedge funds have proven to be great generators of wealth for those who manage them, investors themselves have rarely reaped the benefits.

Lack found that even though investors were taking all the risk, the industry was taking 84% of the $449 billion in total profits. To repurpose a quote from Winston Churchill: Never before in history was so much taken by so few from so many.

Lack’s new book, “Wall Street Potholes,” continues his effort to shed light on how Wall Street exploits the lack of knowledge among investors, and demonstrates why it’s so critical that investors demand transparency at all times from their investments.

Through detailed analysis of various offerings, Lack and his colleagues show how Wall Street creates products that provide substantial fees to the brokers (and so-called advisors) who sell them, while in most cases providing disappointing results for investors.

Unlisted REITs
Lack begins with an analysis of nonpublicly traded REITs (which, although registered with the SEC, are unlisted). These products have limited liquidity (for which investors should require a significant illiquidity premium), and in some cases, have no liquidity 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 shares.

Lack asks the obvious question: If the REIT has gone to all the trouble to register the securities, why don’t they have the shares listed? Going public provides liquidity for investors; thus, investors are more willing to pay a higher price for the shares. That lowers the cost to the issuer. Of course, there are incremental costs to going public, but they should be more than offset by the lower cost of capital to the REIT.

Lack’s answer is that the REIT doesn’t want to attract the attention of sophisticated investors who would look under the hood and see the egregious level of fees embedded in the “small print” in the registration document, which will often run into the hundreds of pages.

In other words, non-traded REITs are willing to forgo a lower cost of capital only because their scheme to generate high fees would be exposed. Instead, the REIT relies on commissioned salesforces to dump these products on unsophisticated investors.

A REIT Under The Microscope

In analyzing one particular nontraded REIT, Inland American Real Estate Trust, Lack found the following:

  • The document contained more than 130,000 words.
  • Buried within that tome was the disclosure that not only did the issuance of the shares come with a 7.5% selling commission, they also came with a 2.5% marketing commission and a further 0.5% due diligence allowance. That’s a total of 10.5%. In other words, investors would be paying $100 for something worth only $89.50. How many investors would actually make such a purchase if they knew the true costs?
  • Unfortunately, it got worse. The document contained language that allowed for as much as 15% of the proceeds to be taken as reimbursement for costs.
  • The document showed that properties would be managed by an affiliate. Thus, the sponsor of the REIT would generate additional profits from managing the properties, creating clear and significant conflicts of interests. Management fees of 1% were only the beginning. There were also fees of another 2.5% if they bought a controlling interest in a real estate business, and a 15% incentive fee after investors earned 10% (with the incentive fee applying to the entire profit, not just the amount greater than 10%).
  • The document itself contained the words “conflict of interest” 40 times, including stating that there were no arm’s-length agreements. In other words, don’t expect the property manager to charge a reasonable fee. Instead, you should expect it to be unfairly high—otherwise, there would be no need to mention the conflict!

In case you’re wondering, Lack cites a study by the Securities Litigation and Consulting Group that analyzed the returns of 27 nontraded REITs, and found that over the period June 1990 through October 2013, they returned 5.2%, while Vanguard’s REIT fund returned 11.9%.

While the Vanguard investors were enjoying all the benefits of daily liquidity and broad diversification, investors in the study’s nontraded REITs, who had none of those benefits, were underperforming by 6.7 percentage points.

The difference went into the pockets of the sellers and sponsors in the form of commissions and excessive management fees. Now consider that the lack of liquidity alone should require a 3%-plus additional premium. Thus, the risk-adjusted underperformance was more like 10 percentage points.


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