Wall Street Potholes. Simon А. Lack

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 %.