Escheatment used to apply when a property owner died without a will or legal heirs. It was the process by which those assets were transferred to the state. Its meaning has since evolved to include theft of property by the state by legal means. So it was that at the Lack home we recently received a letter from a custodian informing us that under New Jersey state law, a brokerage account with no activity for three years could be seized by the state as un-owned property.

The account in question is a trust for one of our children. There are no fees (a rare benefit of being an SL Advisors family member) and dividends are automatically reinvested, so there is no activity. Moreover, we learned that under certain circumstances the state may liquidate any securities positions on seizure, no doubt creating a capital gains tax bill for the claimant assuming they successfully regain their property. We were able to confirm that we’d rather like to retain the assets in the account and not hand them over to the state’s coffers. But the onus was on us to communicate this wish.

This law is common across most states. The Council on State Taxation rates states based on the fairness of their escheatment statute – New Jersey naturally receives a “D” (the lowest).

Three years is obviously a ludicrously short period of time on which to base such a law. The government’s need for revenues has few good outcomes. As a taxpayer, your best bet is to ensure every investment account has some activity or otherwise looks as if you know of its existence. You may also hope fervently that wealthy neighbors whom you dislike suffer regular memory loss.

An Apocalyptic Fund Story

The Four Horsemen of the Apocalypse, as far as long term investment returns are concerned, are excessive fees, leverage, taxes and over-trading. Any one of these can be relied upon to eat into the results sought by the long term investor. Add an excess of all four and you wind up with a toxic brew that impedes reaching your investment goals and can seriously impair your capital. We recently came across a security which incorporates all of them, and it provides a startling reminder of just how relentlessly capital can be destroyed when these four villains are able to work in concert together. As you’ll see, they have wrought an investment disaster of biblical proportions.

The Cushing MLP Total Return Fund (SRV) stands as a testament to much that is wrong with some of the investment products on offer. Although I often write about Master Limited Partnerships (MLPs), this fund’s focus on our favorite asset class is incidental to the story. The lessons herein apply to any investment.

To begin with, SRV is a closed end fund (CEF). This is an intriguing backwater in which we once dabbled before concluding that there wasn’t enough liquidity to justify the time. CEFs are like mutual funds except that their share count is fixed; consequently, price and Net Asset Value (NAV) can and invariably do deviate from one another. One of the enduring mysteries of the CEF business is why anybody buys Initial Public Offerings (IPOs). With admittedly unfortunate timing, on August 27, 2007 Morgan Stanley led an underwriting of 8.75 million shares of SRV at $20, of which $0.94 went in underwriting fees. So investors were immediately down 4.7% on their investment, and could have chosen to avoid the excitement of the IPO and buy SRV the following day (presumably 4.7% cheaper if it traded at NAV). After all, this was not Google, but simply a fund holding other publicly listed securities. But the machine worked, as it usually does, and investors were duly parted from a modest portion of their funds in exchange for misplaced hope.

SRV is organized as a corporation rather than as a Registered Investment Company (“RIC”), and I’ll spare readers detail of the consequences other than to note that SRV expected to pay 35% of its returns to the U.S. Treasury as corporate income tax (since it is a corporation). SRV planned to use up to 40% leverage, relying on the leverage-magnified returns to cover most of the tax. This only really works when a security such as SRV only goes up, but to point out this possible flaw seems small-minded in the face of such boldness.

The 2008 financial crisis was just months away. The demise of Bear Stearns, collapse of Lehman and government bailout of AIG led many to pray for investment relief. They were dark days indeed. For comparison, we are going to consider SRV’s returns against two other indices; the Alerian Total Return Index (AMZX), and a customized index reflecting SRV’s structure, which uses AMZX with 40% leverage, a 35% tax rate, and 5% expenses (all assumptions lifted from the 2007 prospectus). We’ll call this the Alerian Stupid (AMZS) in honor of the hapless souls who aspired to its results.

In spite of the storm clouds in 2007, the AMZX returned 3.3% for the remainder of the year following SRV’s IPO, and even the AMZS was +1.7%. However, SRV left its initial investors smarting with a -14.4% reduction in the value of their investment. Worse was to come, and markets plunged in 2008 with AMZX delivering         -36.9%. AMZS was only slightly worse, at -37.4%. While leverage amplified the losses, the tax burden is assumed to work as a benefit in a down market rather like a net operating loss (those interested in more detail can find it on our blog under The Sky High Expenses of MLP Funds). SRV quickly parted company with these indices, and turned in an eye-popping -69.3%. CEF experts may note that many closed end funds moved to a substantial discount to NAV in 2008 which exacerbated the fall in price many suffered. However, Morningstar  shows that SRV remained at a premium to NAV fNewsletter August 2015 Chartor most of the year and indeed throughout its life until the end of last year. CEFs usually trade at a discount to NAV and many individual investors trade them seeking to exploit this fact. The consistent premium at which SRV has traded reflects optimism by investors tragically not repaid by results.

In 2009 markets roared back, and SRV delivered an astonishing +118.6%, well ahead of AMZX at +76.4% and AMZS at +60.2% (taxes really hurt that year). Emboldened by this performance, SRV investors drove the premium to NAV up during the year and by early 2010 it reached 40%, an apogee of irrational exuberance that causes wistful nostalgia in today’s investors. At this point Cushing, aided by a different set of underwriters, sensibly exploited the premium by announcing a secondary offering of 6 million shares priced at $10, half the level of the IPO. A 2011 supplement to the 2010 prospectus also revealed portfolio turnover of 301% in 2010 and 526% in 2009 (high turnover is our fourth horseman). Holders of SRV may have thought they were investors, whereas the data suggests a manager frantically trading with little evidence of any thoughtful strategy.

The years since have not been kind to the faithful (and their composition has changed via trading in the secondary market). Inconveniently, SRV has not risen consistently in price so as to most effectively avail itself of the benefits of leverage. The annual return from inception to June 2015 is -10.2%, compared with +4.6% for AMZS and 10.7% for AMZX. It shows the enormous difference between selecting the right asset class (since MLPs have done very well) and the wrong instrument.

The result is that today SRV languishes at $3.45, a country mile from its IPO price and at a discount of over 20% to its NAV. In 2015 MLPs have of course been weak, but the discount suggests that the level of enthusiasm for the stewardship of this fund has finally conceded to the reality of truly awful performance. The financial equivalent of Conquest, War, Famine and Death symbolized by the Four Horsemen have surely been visited upon the holders of this fund. Defenders might find fault with picking on an investment launched back in 2007, at a time when perhaps underwriting standards were lower. They might care to consider the Cushing Royalty & Income Fund (SRF), launched in 2012 and having lost 77% for investors since then for a -34% annual return. Obviously they have found a formula that works, after a fashion.

I have heard reports that a new portfolio strategy has been put in place for SRV and that prospects are better than in a long while for those investors willing to cast the past aside. There will probably be some – for although underwriters deserve blame for bringing poor products to market, self-destructive behavior by investors is also necessary to produce stories such as this one. The right thing for Cushing to do is liquidate the portfolio and buy back shares, thus ending a sorry chapter for an MLP manager that has produced ample wealth for its founders if not always for its investors. At least the remaining faithful would profit from the closing of the NAV discount. However, closed end funds represent permanent capital, in that they generate fees in perpetuity for the manager, and winding the fund up is never going to be as appealing to a commercially-driven operator as trying again with a new set of investors.

Even with the benefit of hindsight, it’s hard to fathom just how the underwriters and manager of SRV ever expected to generate acceptable returns. The tax drag, leverage, fees and subsequent turnover represented a formidable headwind, as shown by the difference between AMZX and our customized index, AMZS. Although SRV appeared just prior to a tumultuous time, overall asset class returns during its life have been good; better, perhaps, than those involved in its creation might have hoped in 2007. It was a structurally flawed security, and its existence reflects poorly on all the firms who have been associated with it. I recently chatted with a friend who was considering entering investment management but worried that he did not possess a sustainable investing edge. His caution was reasonable given his desire to offer a value-added service. However, as I pointed out to him, in some places the bar is set pretty low.

The Sky High Expenses of MLP Funds

If the arcane tax accounting of the mutual funds and ETFs that invest in Master Limited Partnerships (MLPs) is of no interest to you, let me save you some time and advise you to skip reading.

As the rest of you who have proceeded past the warning probably know, the attractive tax-deferred yields offered by MLPs require the investor to receive K-1s rather than 1099s at tax time. Many investors want to invest in MLPs without K-1s, and consequently funds were launched that provided a solution, of sorts. ’40 Act funds can hold MLPs on behalf of their investors and provide 1099s, but they may have to pay corporate tax on the returns. If the fund is RIC-compliant, in that it owns less than 25% publicly traded partnerships (i.e. MLPs), investors get pass-through tax status. However, if the fund is not RIC-compliant it is structured as a C-corp and subject to corporate taxes. So the result is that the investors in non-RIC compliant funds only receive 65% of the return (i.e. 1 minus the 35% corporate tax rate). The Mainstay Cushing Fund (CSHAX) is an example, but there are others. Unfortunately, $52BN of the $64BN invested in MLP investments via ’40 Act funds are structured as C-corps (Source: Alerian). Ron Rowland wrote about this issue as long ago as 2010.

The tax drag shows up as part of the expense ratio, so CSHAX sports an eye-popping 9.42% expense for the year through 2/27/15, of which 7.49%-7.94% is taxes. Other funds are similar. Remarkably, few investors are aware of the tax drag in the MLP investment funds they own. Not surprisingly, it’s hard to get anywhere close to the benchmark Alerian Index under such circumstances, since such funds solve the K-1 problem by throwing substantial amounts of their investors’ money at it — or more accurately, to the U.S. Treasury.

There is an odd sort of silver lining to this tax drag though; it works in both directions. Just as the fund delivers 65% of the upside, it also delivers 65% of the downside. As MLP investors are painfully aware, prices have been in retreat since last August, and in recent weeks retreat has become rout. Since the tax bill comes from unrealized gains, a reduction in those gains through a drop in market prices reduces the future tax bite commensurately. It results in lower volatility, which is normally a desirable quality for investors although in this case of dubious value; volatility could be further reduced if the corporate tax rate was increased beyond 35%, which is clearly not the type of risk management investors want.

There is an interesting and so far unanswered dilemma that can face such a taxable MLP investment product during an extended market turndown (perhaps such as the one we’re enduring). Just as the Deferred Tax Liability for unrealized gains can fluctuate with market moves, it can in theory become a Deferred Tax Asset (DTA). This can come about when the non-RIC compliant investment fund holds investments that are at a mark-to-market loss, such that rather than creating a future tax burden they represent something similar to a tax-loss carryforward, or a net operating loss. CSHAX among others seems to contemplate holding a DTA where market moves create one, according to its prospectus. This has the effect of increasing the fund’s NAV above what it would be simply based on the securities it holds. However, the accounting can quickly get tricky if investors begin to exit the fund. This is because an exiting C-corp ’40 Act investor that receives an NAV on their shares subsidized by the DTA leaves behind a fund that is now slightly smaller but has the same DTA, meaning the DTA represents a larger share of the remaining investors’ NAV. Continuing redemptions could propel this process to where benefiting from the DTA was no longer plausible, at which point the DTA could be subject to a “valuation allowance” (the language in the CSHAX prospectus). At that point, the fund might be in the unenviable position of providing investors still only 65% of the market upside combined with 100% of the downside, a set of circumstances likely to induce further redemptions, exacerbating the situation. As the funds themselves point out, the appropriate tax treatment is not clear. It’s an untested area.

This is theoretical. We haven’t actually seen this play out yet, but it’s a useful scenario to consider for such investors.

What should you do? If you own an MLP mutual fund or ETF, look carefully at the expense ratio. Funds set up as C-corps (i.e. not RIC-compliant) are an expensive way to access the asset class, and are unlikely to offer satisfactory returns. The best course is to sell and consider replacing with a RIC-compliant fund. At least the harm of the original investment error has been mitigated by the recent sell-off, since the tax treatment has cushioned the losses you’ve incurred. And if the Deferred Tax Liability of your MLP investment fund is heading in the direction of becoming a Deferred Tax Asset, with its uncertain ultimate realization to the fund, consider a more speedy exit.

How ironic that investors seeking to avoid the tax complexity of K-1s are nonetheless facing tax complexity of a different sort.

We also run a RIC-compliant mutual fund, and you can learn more about it here.

Nothing in this blog should be construed as offering tax advice.  Investors should seek their own tax adviser or tax attorney.  This document is not an offer to purchase or sell, nor a solicitation of an offer to purchase or sell an interest in a Fund.




The Enormous Misunderstanding About MLP Funds and Taxes

Inspiration for these posts often comes from conversations I’ve had with investors during the prior week. For a great many investors, the decision to invest in an MLP mutual fund or ETF goes something like this:

1) MLPs have generated attractive historical returns over (choose your time period) number of years

2) The yield on the Alerian Index is around 6%, which looks good.

3) But MLPs generate K-1s, which I don’t understand and my accountant hates

4) However, there are mutual funds and ETFs which invest in MLPs but give you a conventional 1099

5) I should invest in one of them

What this analysis misses is the heavy tax burden these funds endure, which sharply reduces the returns to investors. The conversion of K-1s received by the fund into 1099s received by the ultimate investor comes at the price of a 35% corporate income tax on those returns. So you’re going to receive 65% of what the fund actually receives on its investments.

There are many examples; let’s look at the Mainstay Cushing MLP Premier Fund (CSHAX), whose Fact Sheet reveals an expense ratio of 6.97% to 7.72% (depending on the share Class). They call it a “Gross” ratio (which is an apt name because it is pretty gross) to highlight that most of the expenses do NOT go to the manager. They go to the U.S. Treasury instead. These expenses are still borne by the investor though. CSHAX has returned between 5.7% and 7.1% (depending on share class) since inception in October 2010, compared with 9.4% for the Alerian Index. In fact, it correctly doesn’t compare its performance with the benchmark nor seek to achieve an equivalent return. It can’t.

Goldman’s MLP Energy Infrastructure Fund (GMLPX) has an expense ratio of 3.16% to 3.56%. Most of the MLP funds out there pay substantial taxes. Although MLP returns have been good — for example, the Alerian Index has returned 14.28% per annum over the five year period through April 2015 — the investors drawn to the sector by this history and the attractive prospects are unlikely to earn close to the returns of the index by investing through funds like these because of the tax drag.

Now that a few years of performance have revealed how poorly these funds do against the benchmark, the reality of the huge tax drag is becoming apparent to many investors.

It’s worth looking carefully at the MLP funds you own to see if you’re contributing substantial chunks of return to the U.S. Treasury. Not all funds are structured in this way. And those that are not subject to corporate income tax only need to earn 65% of the pre-tax return of the funds that are subject to the tax to do just as well for their investors. It shouldn’t be hard to do substantially better.

The Hidden Tax Bite of MLP Funds

Master Limited Partnerships (MLPs) are inexorably linked with those annoying K-1s in the minds of many investors, complicating tax reporting. For some people it’s one of the few things they know about MLPs and the muttered warning of their accountants to avoid K-1s keeps them away from the asset class. Direct holdings of MLPs are the most efficient way to invest in the sector, and in my experience the K-1s aren’t that big a deal. MLPs fully understand the barrier tax reporting represent to many potential investors. As a result, almost all MLPs now provide K-1s electronically and they are issued well before the April tax filing deadline. I’ve also yet to identify an accountant who will put a price on the additional cost of including a K-1 in a client’s tax return. Even at $100 each and a dozen K-1s, it’s well worth it for a portfolio of $500K or up invested in MLPs.

Not everybody has that much to invest, and others may nonetheless still prefer a simpler tax return consisting fully of 1099s for their tax reporting. Ten years ago I seeded Alerian Capital Management’s hedge fund when I was at JPMorgan. Much time and many expensive hours of tax advice were spent trying to come up with a way of maintaining the tax deferral benefits available to direct investors in combination with the simpler tax reporting of a 1099. The bottom line is, there is no way to do it. In this respect, the tax code is watertight. You can hold MLPs with K-1s, or you can invest through a vehicle that provides 1099s at the cost of a substantially greater tax burden.

For many years the industry didn’t spend much energy on the less efficient, 1099 route. But in recent years that has changed, as it turns out there is a ready pool of buyers who will sacrifice quite a lot for tax simplicity. In fact, the solution is a pretty blunt instrument in tax terms. Holding MLPs in a corporation (a “40 Act Fund”, which is a mutual fund or exchange traded fund), solves the tax problem by simply paying 35% tax on the returns. You can have MLPs with K1s, or 65% of MLPs with 1099s. Many people choose the latter, to the evident amazement of people in the industry. An example is the Mainstay Cushing MLP Premier Fund (CSHAX and CSHZX). I remember Jerry Swank, Cushing’s CEO, at a conference some years ago commenting with incredulity at the interest in a competitor’s exchange traded fund (ETF) which solved the tax reporting problem with the 35% haircut. But consumers know what they want, and Cushing subsequently provided it to them.

I wonder how many really know what they’re buying? CSHAX sports a yield of 6.34%, slightly above the yield on the Alerian Index of 6%. It invests in MLPs. But looks can be deceptive; CSHAX has underperformed the Lipper Energy MLP Fund for each year of its existence. Its expense ratio for 2013 (the most recent year available) was a whopping 9-10% (depending on the share class). Most of this (around 8%) is the “Deferred Income Tax” expense, which is the 35% Federal corporate income tax bite that the fund pays in order to provide those 1099s. 2013 was a great year for MLPs so the tax drag is unlikely to be that high every year. But it will nonetheless be an ever-present penalty, eating up a portion of results year after year. Due to a quirk in the way yields are reported, the 6.34% yield advertised by CSHAX is essentially what the fund pays BEFORE adjusting its NAV down to reflect the tax liability. The net, after tax result to the investor is inevitably lower, and that’s before they pay their own taxes.

Like many things that retail investors buy, it’s disclosed but probably not understood. ’40 Act companies that maintain MLPs at less than 25% of their holdings qualify for pass-through treatment, which means the deferral characteristics carry through to the investor. It’s the best you can do in terms of holding MLPs and avoiding K-1s. We run a mutual fund that offers this structure.

Another Implausible Investment Scheme Blows Up

You’d think that following the collapse of Bernie Madoff’s Ponzi scheme in 2008, all investors would have developed a more skeptical protective layer to ward off those who would dishonestly separate them from hard-earned savings. Sadly though, examples regularly occur of the gullible being fleeced.

Joe Lewis ran a currency trading business from Istanbul, Turkey that promised monthly returns of 1-3% (annually this compounds to between 12% and an incredible 42%). In spite of these implausibly high returns, not everyone was put off by such a promise. Consequently, there were many recipients of a series of recent e-mails admitting that not much currency trading had been going on after all, that the business had lost “almost all of its assets,” and that, “…contrary to what was reported to you previously, you cannot expect any payments in the future.”

One poor victim lamented that, “I have never met the bloke and I don’t think I have ever spoken to him.” I bet he regrets that now, but what on earth was he thinking in handing over his money under such circumstances and with so little care?

Part of the appeal was evidently golf trips for clients to exotic locations, as it turns out funded by the clients to a far greater degree than they originally suspected. Mark Bavin organized the golf and helpfully steered investors to Joe Lewis, but now claims he was taken in just like everybody else. Mark may be a thoroughly nice chap but evidently didn’t find much use for a financial services background. On LinkedIn his most recent role was as owner of Mulberry Executive Cars before his current title of simply “Golf Ambassador.”

Harry Markopolos once signed my copy of his gripping book, No One Would Listen; A True Financial Thriller when we had the opportunity to meet before a presentation he was giving. Joe Lewis’s victims certainly would have benefited from reading “The Madoff Whistleblower’s” account of the many warning signs about Madoff available to those willing to do some work, like Harry. The memorable inscription when he returned my signed copy of his book to me was, “Assume Fraud Until Genius is Proven”. It’s pretty good advice.



A Good and a Poor View on the Value of Liquidity

A couple of months ago Roger Ibbotson and I were both presenters at a CFA Conference in Toronto. Ibbotson is a professor of Finance at Yale School of Management and also chairman of Zebra Capital Management, an investment firm whose style of investing reflects his work. Liquidity as an Investment Style was the title of his presentation, based on his recent academic paper.

Investors like liquidity. Not everybody agrees on its definition; for some it is measured by volume. This superficial metric is used by proponents of High Frequency Trading (HFT), since they argue more volume is always good for investors. The issue of HFT’s utility to markets is complex, albeit more widely debated thanks to Michael Lewis’s book Flash Boys. But measuring volume alone is too simplistic because it doesn’t capture potentially adverse activity by algorithms that can increase the costs of trading for others. The actual transaction cost incurred by an investor is a more useful measure, although devilishly hard to measure precisely. Some look at the bid/ask spread to estimate this; institutions that trade heavily use more sophisticated tools that compare their actual transaction prices with market prices prior to their activity to estimate their cost to trade.

Private equity investors often set their return target with reference to returns in public equity markets, such as 5% over the return on the Russell 2000 (a small cap index more reflective of the companies that private equity funds finance). Our strong preference for the flexibility to change our minds makes private investing highly unattractive, so we only invest in publicly listed companies. It’s not that we trade a lot – in fact, far from it. But liquidity reduces the penalty for mistakes and their early recognition allows redeployment of capital to more attractive places. Investment relationships with private equity managers can last ten years or more, and if the actual outcome doesn’t resemble the glossy brochure shared at inception, it can truly feel like purgatory.

Moreover, when you dig into the research it turns out that the illiquidity return has a very narrow source. It comes from a handful of stocks in the bottom quartile of liquidity suddenly becoming momentum stocks, no doubt because of a positive development. The vast majority of illiquid stocks stay that way; over the period covered (1972-2011), just 1% jump from the bottom to the top quartile, more than doubling in value as they go (returning 109%). Another 3.5% jump to the next highest quartile, returning 61%. So if you own the bottom quartile of stocks you might expect that 4.5% of them will generate just over a 3% excess return (that is, 1% X 109% added to 3.5% X 61%). That’s a good portion of what the phenomenon is worth, and such a narrow source of return likely means that it varies substantially from one year to the next. If the annual returns to illiquidity vary widely, investors are likely to experience markedly different outcomes from seeking to exploit it. This also makes it much harder to persist with the strategy during the inevitable disappointing years, and means it’s probably hard to profit from the concept.Liquidity as an Investment Style takes the view that less liquid stocks offer higher returns than more liquid ones. If liquidity is desirable then it makes sense for investors to set higher required return targets for securities whose entry and exit is more costly. This is not news for most people, but Ibbotson’s paper seeks to measure the additional return illiquidity offers. It goes on to posit that illiquidity itself can be a source of “excess return”. There are some factors that are already acknowledged to be a long term source of return. Value Investing is one (variously defined, but generally a focus on stocks with low P/E ratios or sometimes low Price/Book Value). Momentum is another, which consists of buying what’s going up and dumping what’s going down. Such concepts work more often than not, but by no means all the time. The idea that Illiquidity could be another factor like these is interesting, although personally I’m less comfortable with it. The lower return that liquid stocks offer (think of it as the “liquidity discount”) provides the holder with the comfort of an easy exit should they so decide. Stocks are not just sold because of bad news. Sometimes investors need cash for reasons quite unrelated to what they’re selling, maybe for reasons that were not anticipated. A self-styled long term investor owning illiquid stocks to profit from this may be surprised to find their outlook is not as long term as they thought. Liquidity provides the flexibility to change your mind, and in that respect is different than the factors such as value or momentum listed above.

Nonetheless, it is an interesting perspective and worth reading if you care about such things. That illiquidity should offer higher returns is widely accepted in Finance.

Not everybody agrees, however. To find the naysayers we must revisit a topic I have covered before, non-traded Real Estate Investment Trusts (REITs). This particular backwater of Wall Street seems to harbor many of the things that give Finance a bad name. Non-traded REITs (NTRs) are notable for underwriting fees as high as 15% (paid by the investor and shared with the broker recommending the investment); additional fees when the NTR buys properties, maintains them and sells them; numerous conflicts of interest; and no public market liquidity. As registered securities they can be sold to anybody. As unlisted securities they don’t draw much research because there are no commissions to be earned from trading. Their multiple investor-unfriendly features are why their sponsors operate in that regulatory gap: an illiquid security whose sale would normally be restricted to sophisticated investors, but whose SEC registration renders them publicly available.

While the illiquidity of NTRs ought to mean they have a higher expected return (i.e. need to be sold to investors at a lower price to compensate), some proponents have sought to turn this hitherto unattractive feature into a selling point. Sameer Jain is the Chief Economist of American Realty Capital (a big distributor of NTRs). Jain is a graduate of both MIT and Harvard, so presumably has a passing familiarity with financial theory. And yet, on a website recommending his chosen sector he lists as one of the advantages, “Illiquidity that favors the long-term investor”. As he goes on to explain, liquid REITs are inferior because “…the share price can drop below the value of the underlying real estate”. By contrast, because you can’t sell an NTR you benefit from, “…the inability of investors to “panic sell” their securities.”

Jain further notes that conventional, publicly traded REITs are subject to more market volatility than NTRs which, he asserts, makes them more risky. This is because NTRs don’t trade, and they update their asset values infrequently. Of course, publicly traded REITs aren’t inherently more risky, their prices are simply more current. Yet Mr. Jain argues that, because your brokerage statement will show fewer fluctuations in NTRs (because there are no new prices), rational investors (as oddly defined by Jain) should demand a higher return for publicly traded REITs versus the NTRs he prefers. He wants you to choose the illiquid security over the liquid one. This is in spite of the fact that the Financial Industry Regulatory Authority (FINRA), which regulates American Realty Capital, has a warning on its website that the, “Lack of a public trading market creates illiquidity and valuation complexities for NTRs.”

What’s wrong with this is that Sameer Jain’s educational background leads the casual reader to assume he’s intelligent. Evidently, the presumption of a high IQ should not be confused with a genuine desire to offer investors good advice. It’s hard to comprehend why he holds such a view, and causes one to consider an alternative plausible explanation, that he’s disingenuously offering “advice” that benefits his business while believing something different. When Wall Street analysts were caught doing this during the bubble it resulted in large fines and the subsequent inclusion of an Analyst Certification on every report saying that the writer believed what he wrote. Of course it shouldn’t have been necessary, and yet you can still find examples of people writing what they surely know cannot be right.

It’s what gives Finance a bad name. Daylight is often the best disinfectant.

This was originally published in our December newsletter. 


A Scandal That Should Shock Nobody

I was struck the other day by some of the commentary on Seeking Alpha surrounding American Realty Capital Properties (ARCP). ARCP is a REIT. Their chairman is Nick Schorsch, who is also chairman of American Realty Capital which is built around the origination and distribution of non-traded Real Estate Investment Trusts (REITs). While conventional, publicly traded REITS have their place in an investor’s portfolio, the non-traded variety represent a far more dubious sector.

In February I wrote about a non-traded REIT,  Inland American Realty (not managed by ARCP). Like many others,it’s a great investment for brokers, but far worse for their hapless clients. It includes features such as 15% of your investment as fees up front, additional fees for buying and managing properties, incentive fees and myriad conflicts of interest, in addition to which you can’t sell it because it’s not publicly listed. Foregoing a public listing is sensible if you’d rather not invite the attention of sell-side research analysts to the egregious fees you charge buyers of your product. No public listing means no trading, so no commissions and not much point in writing about it if you work for a sell-side research firm.

This is of course all disclosed, and therefore quite legal. American Realty Capital is the largest manager of non-traded REITs, with a portfolio of $30BN in assets. But the growth of the industry speaks more to the power of high fees to induce some brokers whose clients’ interests lie substantially below their own to push such products. It’s hard to conceive how anybody associated with an investment that starts life pocketing 15% of your money could in good conscience claim to be helping you grow your savings.

So now we turn to the recent news on ARCP, which is that it is being investigated by the SEC for knowingly mis-stating its financials. Two employees have resigned because they apparently concealed the mis-statement. Their bonuses were set to be higher with the higher figures.

The stock has fallen 40% since the disclosure, as the company has announced that 2013 financial statements previously issued could no longer be relied upon. Some investors wonder publicly whether to hold or sell, seeking to balance what they perceive as the good versus what is reported to be the bad in their comments.

And yet, ARCP is headed by someone who has built a business by selling  securities through ethically-challenged, fee-hungry intermediaries with little regard for the reasonableness of the resulting economics for their clients. ARCP is not American Realty Capital (their confusingly similar names initially confused me as well) but if a company’s tone is set at the top,  ARCP is run by someone who clearly cares more about fee generation that the interests of his clients.

It reminds me of Bernie Madoff. Many of his investors believed that his persistently attractive and steady investment returns were derived from the ability of his hedge fund to front-run the orders of its brokerage clients. Harry Markopolos reports that this was so in his terrific book on Madoff’s scam, No One Would ListenAs hedge fund investors, they thought they were the passive beneficiaries of such illegal behavior. They believed they incurred no risk, and probably expected that if the front-running behavior was detected, the authorities would simply punish Bernie Madoff but not his investors. They were perfectly fine investing with someone that they knew to be dishonest, reasoning that the dishonesty was directed at unwitting others and that their crooked investment manager was honest with them. Such tortured logic delivered its own type of just reward when the truth revealed no such profitable front running activity at all, delivering large losses to the gullible.

The analogy of ARCP with Bernie Madoff is not perfect, but the non-traded REIT business is not an area that reflects well on the people who traffic in them.  It’s not a nice business. ARCP investors should look carefully at the people with whom they’re invested.

With Options, Less Can Be More

This weekend the Striking Price column in Barron’s referred to the Options Industry Council’s educational series of videos. I have to say I have mixed feelings on the topic. On the positive side of course educating investors is a good thing. The videos currently available are extremely basic, offering definitions on terms such as “strike price” or “in the money”, but presumably there will be additional offerings that will explain how options can be used in various strategies.

The negative element is that the vast majority of individual investors really ought not to be using options at all. At their most basic, options introduce leverage and leverage makes the timing of an investment return far more important than it ought to be. Buying call options on a stock you think will rise will never be as profitable as buying the stock, if the stock rises. Buying put options to protect against a market fall is not as good as limiting your overall exposure to that which you can sustain through a market fall.

Options turn investors into traders, and while this is good for the options industry and for firms that make markets in options, transactions costs, taxes and missed opportunities will render long term returns lower than they would be otherwise. In short, for the majority it’s fair to say that the less time you spend on options the richer you’ll be. FINRA’s Investor Alerts page offers a lot of sensible advice, but including advice to focus on the long term term is probably a step too far.

For many years I ran an interest rate options trading business. Broadly speaking, market makers are more often sellers than buyers of options. It’s too much of a simplification to justify this bias by saying most options settle worthless, but the demand is heavier from those seeking protection (i.e. paying the option premium) than the reverse.

Warren Buffett made an interesting options investment some years ago (it was in long dated options with ten or more years to expiry; exceptionally far out and therefore an exception to the notion that options are usually for traders). In effect he bet that the Black-Scholes (B-S) formula  so often used to price options is flawed. B-S takes today’s security price and extends it out into the future at the risk free rate to estimate its future value. The volatility of the stock reflects the model’s confidence that the stock in question will be at that projected level when the option expires.

By selling long dated options priced this way, Buffett was acting on his conviction that projecting out today’s value for the S&P500 at the yield on the ten year treasury note (i.e. the risk free rate) understates the likely level of the S&P500 in ten years time. The B-S assumption allows for an elegant algebraic solution to the price, but in Buffett’s view the solution was wrong. So Berkshire sold put options on the S&P500 to B-S reliant options market makers, based on his insight that their models were assuming the future price of the S&P500 to be too low and therefore overvaluing the put options they were buying.

Berkshire had to stop adding such trades because of the possibility they’d have to post margin if the trades moved against them, which in an extreme case (i.e. very weak equity market) might have tied up more liquidity than was prudent to support their insurance business. The settlement dates extend into the next decade, so it’ll be many years before the result of those decisions is known. Berkshire’s 2013 10-K noted $2.8 billion in gains from equity index put option contracts whose fair value (i.e. what Berkshire owes at current prices) has dropped to $4.8 billion (excluding premium taken in).

However, I doubt the Options Industry Council will publish videos on how to trade options like Warren Buffett. Like alcohol, best used in moderation.

What Type of Financial Advisor Advises You?

For individual investors seeking advice, the world they enter can be a confusing place. I’m thinking here of the different types of financial advisors that offer to help investors deploy their capital.  Non-finance people shouldn’t need to bother themselves with subtle elements of the investing regulatory landscape, but there are some things they’re better off knowing. Financial advisors don’t all operate with the same set of objectives. Some, who work for investment advisory firms and are Registered Investment Advisors (RIAs) are bound by the 1940 Investment Advisors Act to conduct themselves as a fiduciary, meaning they’re legally obliged to put their clients’ interests first. It seems like a sensible standard, but it’s not the only standard. There’s another class of financial advisor who work for broker-dealers rather than investment advisory firms. Their activities are bound by a lower standard of suitability and disclosure.

A financial advisor who is an RIA and works for an investment advisory firm has to put the client’s interests first. A financial advisor working for a broker-dealer may not be so constrained. It’s as if the RIA is sitting next to you, the client, at the table working with you to identify and implement an appropriate investment strategy, while the broker-dealer version of a financial advisor is sitting across the table from you trying to sell you something.

Neither model on the face of it is necessarily better than the other. In our business at SL Advisors we are fiduciaries and we believe that is best for clients. But the non-fiduciary type of advisor may be more appropriate for some people. When you buy legal or medical services you’re dealing with somebody who has to put your interests first. When you buy an automobile or a house, you’re not. Many people wouldn’t want to make those purchases through fiduciary relationship. It’s well understood that in buying a car you need to do your homework and that the car salesman is obviously promoting the positive aspects of the car. There’s no need to employ your own agent to negotiate with a car salesman on your behalf.

The interesting question is whether the typical investor, when buying financial advice,  can recognize the difference between a financial advisor with a fiduciary obligation and one without. The term “financial advisor” is confusing because it sounds a lot like someone whose unequivocally on your side. You need to understand the difference, and in particular whether or not they work for an investment advisory firm (fiduciary obligation) or a broker-dealer (probably, though not always, no fiduciary obligation). So next time you’re talking to your advisor, ask whether they’re the fiduciary type or the car salesman type.

The 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act directed the SEC to evaluate whether a uniform fiduciary standard should apply to all financial advisors, not just those employed by investment advisory firms. The SEC duly did this and concluded that it would be a good idea. The brokerage industry successfully lobbied against this. They argued that it would be adverse for certain types of clients for whom coverage would no longer be commercially attractive. But there’s also little doubt that it would impede the ability of broker-dealers to market some fee-laden products such as non-traded REITs (with as much as 15% of upfront fees), many varieties of structured notes and other illiquid yet expensive products. It would create enormous challenges for municipal bond dealers whose profitability hinges on the mark-up they can add to a bond before selling it to the client. Being a fiduciary is inconsistent with profiting from any of these transactions when they’re sold to clients. The car-salesman type of financial advisor is far more likely to have their client invest in a non-traded REIT than the fiduciary type of advisor, because the car-salesman receives some of the upfront fees whereas the fiduciary type does not.

So two types of financial advisor will remain for the foreseeable future. But there’s still plenty that can be done to ensure that investors are better informed about the relationships they have and the investment products they’re offered. FINRA (The Financial Industry Regulatory Authority) publishes an “Investor Alert” section of its website. Its existence is not widely known, and yet it contains a great deal of basic, sound advice for self-directed investors interested to learn more. It also includes warnings on certain products (such as non-traded REITs, structured notes and the potential mark-up on municipal bonds). You’d think that the existence of such warnings from a government regulatory agency would give pause to any financial advisor (fiduciary or otherwise) selling such instruments. Maybe many do steer clear, mindful of the problems FINRA highlights, but clearly they don’t all do so.

It would seem to me a fairly obvious thing for a certain class of Investor Alert to be provided to any client prior to making a purchase. Given all the problems with non-traded REITs, why not require that any buyer be directed to the website before buying? Smokers still buy cigarettes with their government warnings. Let people make their own decision, but at least make sure they’ve been provided relevant information. If FINRA feels it necessary to issue a warning about a certain security, that ought to be known to every potential buyer. The CFA could take the lead on this issue by advocating for such communication to investors prior to a trade involving the security subject of such a warning. It would be a logical extension of the CFA Institute’s support for a uniform fiduciary standard across all financial advisors.

Even if that fairly simple step doesn’t happen, there’s nothing to stop financial advisors from conducting their business in a way that’s consistent with such investor alerts being widely known. In fact, you’d think that any reputable financial professional or firm would feel queasy at the least in profiting from securities highlighted in this way by FINRA. The financial services industry has been the subject of withering reputational attacks, some of them justified and due to self-destructive behavior. The resulting populist outrage at Wall Street and ever greater regulatory burden are the political result. Investors deserve better, and many financial professionals don’t deserve the opprobrium heaped on the industry. It’s time for us to start regaining trust by behaving in ways that reflect common sense regardless of whether the law requires it. Individual financial advisors need to conduct their business with the client’s interests first  whether or not they have a fidiuciary obligation to do so. If advisors swore off selling products that are targets of FINRA’s Investor Alert website that would be one step towards taking back the industry’s reputation.