I will be presenting as part of a BrightTALK/Morningstar conference panel on alternative investments at noon ET/9 am PT today (July 25) as part of their Investment Summit, an online event designed for financial advisors to gain insights from industry thought leaders on investing in a volatile market and to continue conversations initiated at the 2012 Morningstar Investment Conference. I hope you will participate. There will be a replay available.
I will be presenting as part of a BrighTALK/Morningstar conference panel on alternative investments next week (July 25) as part of their Investment Summit, an online event designed for financial advisors to gain insights from industry thought leaders on investing in a volatile market and to continue conversations initiated at the 2012 Morningstar Investment Conference. I hope you will participate.
The piece that had been available here is going to run in the September issue of The Journal of Financial Planning, so I have removed it from here until then. I apologize for my error.
Contract killers are not typically hired simply because they are available. I won’t decide to kill my wife solely because Luca Brasi is around, even if he is offering a discount. There has to be a perceived need for contract killing (as Byron Fisher sagely points out) — I have to want (a lot— given the risks) to kill my wife — for Luca to be in business. In other words, the general public must demand the services of contract killers before contract killers start supplying their services to the general public.
Thus demand will always create supply. There aren’t very many purported economic “laws,” and even fewer that are well-supported by the data — but this is one that has been true throughout human history, and I don’t expect it to change any time soon. If demand exists, entrepreneurs will create products and/or services to meet that demand.
When demand is especially great, new kinds of (not-so-great) supply often emerge to meet it. For example, when Wall Street investment banks had huge demand for CDOs generally but no ready outlet for the lower-rated tranches, they “created the investor” to buy that paper. Accordingly, they became desperate to obtain more sub-prime mortgages to fuel their CDO machines, which caused mortgage companies to create riskier and riskier, stupider and stupider mortgages to meet that demand and thus inflate the housing bubble.
Similarly, in times of historically low bond and related yields (and low rates generally), in an effort to kill off various threats to a portfolio and/or to satisfy income needs of various sorts, it shouldn’t be surprising that many investors are reaching for yield. In so doing, many take on much greater risk and suffer much greater illiquidity in order to find a bit of yield. Reaching for yield is as old as the hills but often doesn’t turn out well. JPMorgan Chase’s admission yesterday of a $2 billion trading loss in derivatives — still unrealized at this point, which means they have not yet been able to unwind all the trades and that the losses may continue to grow (explained here) — was based upon just such a reach (as Charles Peabody describes for Bloomberg TV viewers here).
Whether we are talking about munis, junk, MLPs, bank loans, emerging markets debt, traded REITs, non-traded REITs, or even high quality dividend stocks, reaching for yield adds significant risk and often has dreadful consequences. In March 2009, after General Electric’s stock price had plunged 72 percent in a year, that bluest of blue chips added insult to investors’ injury by slashing its dividend by 60 percent. Whether the issue is credit risk, interest rate risk, complexity risk, currency risk, liquidity risk or market risk, adding risk is — well — risky.
Savvy investors should consider every possible avenue for investment success, including the “yield vehicles” outlined above. But they should do so in the context of overall value. When investors’ focus is on yield, return and growth to the exclusion of risk, the outcomes are often bad ones. Sometimes these risks can even be fatal, as Luca Brasi discovered similarly (see below).
Yield is in great demand, which suggests that it will tend to be overbought and that the vehicles created to meet it should be scrutinized carefully (think sub-prime mortgages, for example). Reaching for yield is an expected play in times like these. But before you try it, be sure it’s truly a value play and not a careless reaction to difficult times.
Background. As I have written and discussed numerous times, we remain mired in the throes of a secular bear market, prone to major swings in both directions. This reality has led to much discussion of the alleged “lost decade” for stocks. How much longer this secular bear market will last is impossible to tell. But for as long as it does, we cannot expect much long-term equity appreciation (despite the likelihood of significant cyclical periods of good performance – such as that we are seeing right now).
For most of this past decade, poor stock market performance has been mitigated by an ongoing rally in bonds – a rally that has continued for roughly 30 years. However, historically low yields most recently have made the bond markets less attractive generally for many investors and especially for those with the need or desire for income. As John Hussman (among many others) has pointed out, “nearly every traditional asset class is priced to achieve miserably low long-term returns.”
At the same time, as is now well documented, the amount of “safe” assets available for investment has diminished considerably.
In an environment that is fearful and which does not trust traditional diversification strategies to provide the level of downside protection frequently desired, investors also seek better alternatives than they have typically had available to them in order to achieve their goals. As a consequence, advisors and money managers of various types have increasingly used “alternative” investments (which for these purposes I define as investments which are generally non-correlated to the traditional stock and bond markets) so as to reduce portfolio risk and to provide opportunities for outperformance in this challenging times, inspired by the so-called “endowment portfolio” strategy begun and exemplified by Yale’s David Swensen (even though Swensen himself rejects that type of approach for retail investors).
Comprehensively understood and carefully managed, alternative investments and strategies can indeed offer better ways for advisors to manage risk and to achieve better diversification within their client portfolios. The related desires for both non-correlation and yield have fueled demand for such alternative investments. Unfortunately, for some advisors and investors, “alternative” has meant almost exclusive reliance upon non-traded REITs and other private investments in “hard assets.”
Investors also like the seeming lack of volatility of such non-traded offerings, which are not marked to market regularly – in large part due to the lack of much of a secondary market. However, as SEC Attorney Michael McTiernan pointed out to The New York Times:
“One common sales tactic we object to is the suggestion that they [non-traded alternative investments] are eliminating volatility simply because they don’t tell you what the value is. It’s not that it’s not volatile. It’s just that you don’t know.”
Regulatory Climate. Non-traded REITs and similar private offerings, like all investments, have their weaknesses. Consequently, in light of tremendous demand for them, regulators have responded to the growth of this market aggressively.
In 2009, via Regulatory Notice 09-09, FINRA prohibited broker-dealers from using information more than 18 months old to estimate the value of investments such as non-traded REITs. Such value determinations must consider the underlying value of the investment’s assets as well as its costs, including commissions paid. This regulatory change resulted in significant reductions to current market value estimates in many cases.
This past September, FINRA issued proposed amendments to Rule 2340 governing customer account statements that would require that “all per-share estimated values, including those that are based on the offering price, reflect a deduction of all organization and offering expenses.” In other words, the initial value of non-traded REITs and similar products must reflect the value of the shares net of up-front expenses. That means that the customer of a broker who buys a non-traded REIT for par, typically $10 a unit, would receive an initial account statement that shows a value net of brokerage commissions and other expenses. In such instances, non-traded REITs would be valued in the range of $8.70 per unit. Not surprisingly, the North American Securities Administrators Association supported this proposal. Even the National Association of Real Estate Investment Trusts supports it. I expect it to be enacted in substantially the form in which it was offered.
Shortly thereafter, in October of 2011, FINRA published an Investor Alert, entitled Public Non-Traded REITs—Perform a Careful Review Before Investing, which states that while investors may find non-traded REITs appealing due to the potential opportunity for capital appreciation and the allure of a robust dividend, they should also realize that the periodic distributions that help make non-traded REITs so appealing can, in some cases, be heavily subsidized by borrowed funds and include a return of investor principal.
Additionally, FINRA’s alert says that early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. Gerri Walsh, FINRA vice president for investor education, stated it like this: “Confronted with a volatile stock market and an extended period of low interest rates, many investors are looking for products that offer higher returns in turbulent times.” However, “investors should be wary of sales pitches that might play up non-traded REITs’ high yields and stability, while glossing over the lack of liquidity, fees and other risks.“
Latest Actions. FINRA has now published a 16-page bulletin on its website outlining the priorities and things it is looking carefully at for 2012. Among the items was a mention of REITs and private placements (Investment News summary). In FINRA’s own words:
“FINRA is informing its examination priorities against the economic environment that investors have faced since 2008, as these circumstances have steadily contributed to conditions that foster an increased risk of aggressive yield chasing, inappropriate sales practices, unsuitable product offerings, and misappropriation and fraud….
“Given the low yields on Treasuries, we are concerned that investors may be inadvertently taking risks that they do not understand or that are inadequately disclosed as they chase yields.
“…The lack of a deep secondary trading market for certain investments make them unsuitable for many retail investors who have strong liquidity needs.”
“…Transparent and accurate financial details should be available at the time an investment is made to ensure that investors are making an informed decision. The classification of cash flow returns is particularly important so investors know when returns are being paid from their own principal or from capital raised in subsequent offerings….
“Although non-traded REITs may offer diversification benefits as a part of a balanced portfolio, they do have certain underlying risk characteristics that can make them unsuitable for certain investors. As an unlisted product without an active secondary market, these products offer little price transparency to investors and little liquidity. The related financial information for these products may often be unclear to the investor, which makes the true associated risks and value difficult to ascertain. With many products, there are questions about valuation and concerns that in some cases distributions to investors are paid with borrowed money, over a lengthy period of time, with newly raised capital, or by a return of principal rather than a return on investment. The source of the distribution may not be transparent.”
That same recent bulletin also noted that suitability reviews will continue to be important in 2012, as the new Suitability Rule (FINRA Rule 2111) and Know Your Customer Rule (FINRA Rule 2090) become effective on July 9. Thus all broker-dealers transacting with clients or making investment recommendations to them must comply with new suitability standards established by. This rule, modeled upon NASD Rule 2310 (Suitability), requires that a firm or associated person have a “reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.”
A representative’s recommendation is still the trigger for the rule’s application, and uses a “facts and circumstances” approach in its determination, but makes a number of changes to the institutional investor exemption and clarifies which sorts of information brokers must ask for and analyze before they make recommendations. Previously, the only factors representatives were required to consider when offering investments to customers were investment objectives, tax status and financial status. Under the new Rule, they must also take into account age, risk tolerance, time horizon, liquidity needs, other investments and experience.
FINRA also provided the following guidance concerning the definitions of “risk tolerance,” “time horizon” and “liquidity needs.”
Risk Tolerance: “A customer’s ability and willingness to lose some or all of [the] original investment in exchange for greater potential returns.”
Time Horizon: “The expected number of months, years, or decades [a customer plans to invest] to achieve a particular financial goal.”
Liquidity Needs: “The extent to which a customer desires the ability or has financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value from, for example, the lack of a ready market, or incurring significant cost or penalties.”
In the case of multiple customer accounts, it is possible for different accounts to have different investment profiles. However, FINRA is clear that “a firm could not borrow profile factors from the different accounts to justify a recommendation that would not be appropriate for the account for which the recommendation was made.” Therefore, if an investor has two accounts, one with high risk and one with low risk, broker-dealers cannot use the high-risk profile to justify recommendations for the low-risk one.
New Rule 2090 is modeled after former NYSE Rule 405 and requires member firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer and concerning the authority of each person acting on behalf of such customer.” The obligation arises at the beginning of the customer/broker relationship, independent of whether the broker-dealer has made any recommendation, and continues through termination of the relationship. We should take careful note of the new requirement to “retain” the “essential facts” concerning every customer.
According to Rule 2090’s “Supplementary Material,” “essential facts” are those facts that are required to:
- Effectively service the customer’s account;
- Act in accordance with any special handling instructions for the account;
- Understand the authority of each person acting on behalf of the customer; and
- Comply with applicable laws, regulations and rules.
Essential facts for knowing the customer are defined when read in connection with Rule 2111’s requirement that reasonable efforts be made to gather expanded categories of information about the customer’s “investor profile” (discussed above) in order to evaluate suitability.
Taken together, these new suitability and “know your customer” rules effectively negate the possibility of a “product sale.” Sales now need to be justified essentially as part of a comprehensive and well-documented plan.
While I hope you have read them before, you might also be interested in several of my publications on this general subject from my blog and elsewhere: