Swedroe: Watch Out For Potholes

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.

 

Fiduciary Vs. Suitability Standard Of Care

Lack spends a considerable amount of time explaining the differences between advisors who are required to provide a fiduciary standard of care (the only thing they are selling is advice, and the advice must only consider what is in the client’s best interest) and those who are held only to a suitability standard of care (it’s perfectly fine to recommend a product even if it’s not in the investor’s best interest, as long as it meets the lesser “suitability” requirement).

To make clear the distinction, throughout the book, Lack uses analogies to the medical profession and asks questions such as: Would you ever consider using a doctor who deliberately hurt patients by prescribing products that are dangerous, when superior choices are available?

Of course not. Yet in the financial services industry, complex products are routinely designed to be sold to naive investors, who are exploited because “advisors” are allowed to operate under the suitability standard.

That is why investors should demand that any provider of financial advice put in writing that they are providing a fiduciary standard of care. As Lack demonstrates throughout the book, you’re putting your financial safety at risk if you don’t, and there’s simply no reason not to require it.

Disclosure Vs. Understanding

Lack explains that the disclosures written to provide the legal “cover” for products that exploit naive investors simply are not sufficient, because there’s a clear distinction between disclosure and understanding.

You can be virtually certain that few, if any, investors in nontraded REITs even read the full registration document (they simply relied on their trust in the “advisor” who sold them the product). And you can also be sure that an even smaller percentage of those who bothered to read a multihundred-page document would be able to fully comprehend the costs and the risks embedded therein.

Structured Notes

Lack’s colleague, Kevin Brolley, takes on another entire category of products meant to be sold, never bought, in the chapter titled: “Why Structured Notes Are Rarely the Best Choice.” Structured products are financial derivatives whose payoff at maturity is dependent on one or more classical assets (generally stocks or stock indexes).

Unfortunately, they are “popular” for the same reasons many financial products are popular—either they carry large commissions for the sellers, or they so greatly favor the issuers that they push the products on unsophisticated investors who cannot fathom their complexity (but are assured by the salespeople and advertisements that they are good and often safe products).

As with nontraded REITs, Brolley shows that structured notes are expensive, totally illiquid and often overly complex—with that complexity being intentional, because it is there to hide the huge costs embedded in the products.

In other words, the whole business is designed to exploit the knowledge that advantage issuers have over retail investors, allowing sponsors to generate huge profits for all involved in the production chain, including the “financial advisor” who sells the notes.

And it’s a huge business. Roughly $40 billion or more of these exploitative products have been sold every year since 2010. And that figure only includes notes registered with the SEC.

Lack showed that the typical fee was so steep that investors were buying products that weren’t worth anything close to the par (100) price they were paying. He found the typical true value was between 90 and 96 cents.

In one specific example, he showed that the estimated value of the product on its sale date was just $0.91, with about a 4.5% commission to be paid to the salesperson and an additional 4.5% profit built in.

On top of the egregious spread (you can be sure that no investor would actually have bought the product if they knew the true costs), structured notes lack liquidity. And investors should receive a premium for that. Thus the true value would be something more like just $0.86-0.88.

Products That Prey On The Uninformed
In my more than 20 years of experience advising individual investors, I’ve been asked to review many complex products (such as structured notes), and I have yet to find a single one that any knowledgeable investor would even consider purchasing. And I’ve also yet to ever see one that any institutional investor ever purchased.

Brolley states that he has had a highly negative, cynical view of the products he and other sophisticated investors have examined. He asks: “Suppose a minority of doctors were prescribing medication known to be harmful? Would the others remain silent?” You would think if that were the case, there would be serious consequences. Yet in the world of investing, the exploitation continues, with few—if any—even questioning it.

What’s really scary is that many of these investments are allowed to be sold despite the Financial Industry Regulatory Authority (FINRA) providing public warnings about the dangers of products such as non-traded REITs, certain types of annuities and ETFs as well as structured notes in the “Investor Alerts” section of its website. In fact, in Regulatory Notice 12-03, FINRA has explicitly stated: “Knowledge of the payoff structure isn’t equivalent to an understanding of the risks associated with a complex product.”

To illustrate how complexity is designed to favor the issuer, Brolley’s chapter digs into a recent offering by Goldman Sachs (cusip 38148D3F9), a certificate of deposit (CD) that was tied to the performance of the S&P 500. The structure was highly complex, containing upside potential for the buyer while also providing a minimum guaranteed return of 6% over a six-year period. That sounds attractive. Who wouldn’t want upside with no downside?

 

By applying historical data to the payout formula of the CD, it was found that, of the 58 six-year periods studied, the minimum payout of 6% would have been made 48 times (83%). And the minimum would have been paid out in 48 of the last 49 six-year periods. The average payout was just 6.005%.

In other words, Goldman Sachs designed the complexity in such a way that it kept virtually all the upside while charging large fees. No one would have bought the product if they knew this were the case. It’s this financial complexity that allows the “crime” to be perpetrated.

Hedge Funds

Lack also provides an update on hedge funds. He shows that the average hedge fund has underperformed a 60/40 stock/bond portfolio since 2002, not only over the whole time period, but in every single year.

Yet despite this abysmal performance, over that time period, net inflows into hedge funds continue, with assets under management approaching $3 trillion. Lack provides some interesting insights into why the hedge fund mirage persists and assets continue to flow in. The chapter he dedicates to this subject is one well worth reading.

Given the severity of the problem and the number of potholes that Wall Street creates, are there any simple solutions? I believe there are.

Solutions

First, there’s simply no reason for you to ever work with any advisor who will not put in writing that they will provide you with a fiduciary standard of care. It’s a disgrace that there isn’t a legal requirement for a universal fiduciary standard of care, and I think any politician voting against such a measure should be run out of office.

Additionally, all the arguments against the fiduciary standard of care are outright lies (such as “investors with smaller portfolio would lose access to advice”). I cannot think of a single reason why anyone should ever invest with an financial advisor who’s not prepared to show you that he/she and his/her colleagues invest in exactly the same investment vehicles they are recommending to you. If they are unwilling to meet these two tests, run as fast as you can.

Second, regulators should mandate not only that there must be full disclosure of all costs and risks, but also that the disclosures be put in plain, simple English, all in one place on no more than a page or two (if it’s more complex than that, it’s probably a bad idea). Furthermore, the true value of the product being sold must be disclosed as well, with the value determined by an independent source.

Third, regulation of these complex products should be required. In their University of Chicago working paper, “An FDA for Financial Innovation: Applying the Insurable Interest Doctrine to 21st Century Financial Markets,” Eric Posner and E. Glen Weyl proposed that when a firm invents new financial products, they be forbidden to sell them until they receive approval from a new government agency, The Financial Products Agency, designed along the lines of the FDA, which screens pharmaceutical innovations.

While the FDA can often take years to approve a new product, the review of financial innovations should be much cheaper and faster, because it should involve readily available public data and well-known mathematical calculations.

Demand Fiduciary Duty As The Standard
We’ve seen that investments in derivatives and other product innovations can be just as dangerous to your financial health as taking a bad medicine can be to your physical health. Naive investors need protection from exploitive financial firms seeking not to help them but to plunder them, treating them as Muppets.

If the fiduciary standard were applied to the selling of financial products, it’s likely that virtually all structured notes would disappear. If those selling a product cannot demonstrate that they believe its purchase is in the buyer’s best interest, why should that sale be allowed? I cannot think of a single reason.

Additionally, this standard should be applied to all products, but especially to the whole category of structured products, such as equity-linked CDs and equity-indexed annuities, created by sophisticated financial institutions to sell to naive investors.

Complexity allows the creators of these products to embed fees that are exploitative at best, amoral at worst. Just as broker-dealers can be fined for excessive markups on bonds, creators of structured products should be held to the same rule, with a standard established for what is considered a reasonable fee.

Unfortunately, just as with pharmaceuticals, full disclosures are simply not enough, because the complexity of some financial products is such that there is virtually no chance the typical investor can determine the nature of their fees or perhaps even the risks involved.

How many investors will even read a 70-page disclosure document, let alone a multihundred-page one? This simple recommendation would go much further to protect individual investors and society even than the 2,319-page Dodd-Frank Act.

If these simple rules were adopted, the size of the financial industry would shrink dramatically, and investors would get to keep more of the returns that markets provide, all while taking less risk. Lack certainly deserves a lot of credit for his efforts in bringing these issues to the attention of the public. I highly recommend both of his books.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.