The Mysteries of Closed-End Funds

One of the persistent curiosities of investing is the inefficiency of the closed-end fund business. Closed-end funds have been around for decades. One of the very oldest, Adams Express (NYSE:ADX), claims it has been in continuous operation (Adams Express Company n.d.) since 1929, one of only five funds able to make such a claim. Nowadays, individuals trading their personal brokerage account can access the kind of technology and real-time analytics that used to be limited to large banks and brokerage firms. In so many ways, the financial markets are more efficient. And yet, closed-end funds continue to demonstrate inefficiencies as investors routinely do things that are widely recognized to cost them money.

Closed-end funds (CEFs) are similar to mutual funds in that they are specialized companies (Registered Investment Companies is the legal term) that own securities issued by other companies. Whereas mutual funds continuously issue and redeem shares to investors to balance supply and demand, CEFs have a fixed share count. When you invest in a mutual fund, you're issued new shares in the mutual fund company, which then goes into the market and invests your cash in more of the securities it already owns. By contrast, investing in a CEF means that you're buying some of the outstanding CEF shares in the open market from someone who already owns them.

This is why mutual fund transactions are done at the net asset value (NAV) of the fund, whereas CEF transactions take place at whatever is the prevailing market price for the shares. CEFs often trade at a discount to NAV, meaning that the CEF shares can be bought for less than the portfolio of investments it owns are actually worth. It's a very appealing concept to buy something for less than it is really worth. Of course, stocks can often be found trading at cheaper than their fundamental valuation, although there's almost always a fair degree of judgment involved in assessing that value. Since CEFs own other publicly traded securities, there isn't much room for disagreement about their NAV. Consequently, the opportunity to buy a CEF at, say, a 10% discount to its NAV has attracted legions of investors for decades and will no doubt continue to do so.

We'll return to CEF discounts later on, because there can often be attractive opportunities. The area where investors routinely get duped is when a CEF does an initial public offering (IPO). It's a testament to the ability of Wall Street to spin a good story that CEF IPOs still get done.

For most companies making their initial public offering of stock the underwriters seek to create as much excitement as possible around the event. All the positive features of the new company are emphasized; their new technology, revolutionary business model and breathtaking growth prospects. Sometimes a stock never looks back after its IPO (such as Google), and trades forever higher. At other times, it's a bust (as it was initially with Facebook). But invariably, there's something novel about the investment opportunity, and there's probably no other part of Wall Street that generates as much anticipation as an IPO.

It's harder to justify the same hype with a CEF IPO. After all, the new CEF is simply going to invest the cash proceeds it receives from its new investors in a portfolio of publicly traded securities. There's no new technology or revolutionary business model involved, simply the purchase of some stocks and bonds that were available before the IPO and will be available afterward. And yet, amazingly, underwriters routinely charge 6% of the proceeds as an underwriting fee, which is readily paid by the investors. So quite literally, if you participate in a CEF IPO, the new security you buy at $20 a share (most CEF IPOs are priced at $20) is immediately worth 6% less, or $18.80.

I can see why it might be worth it for the CEF manager to pay 6%. After all, CEFs represent what's called permanent capital. That is, once the money's been raised, the manager can earn fees from investing it pretty much forever, unless he does such a horrendous job that the investors rise up and vote him out (very rare). If a CEF is going to pay management fees to the manager running it of, say, 1.5% annually for many years, paying 6% up front may make sense.

But it's not the manager that pays the 6% fee, but the investors. It's generally the dumb money that buys a CEF IPO at $20. The smarter money waits until the next day, when its price reflects the 6% underwriting fee the initial buyers paid, and invests at 18.80.

Of course brokerage firms (who receive the 6%) will argue that the NAV will rise after the IPO because the stocks the CEF buys will be pushed up its buying. Or that the skill of this particular CEF manager will warrant its shares trading at a solid premium to its NAV, rendering the IPO price an attractive entry point. There may be the odd instance where this is the case, but if you avoid buying CEF IPOs completely, odds are you'll be richer for it.

I once had a conversation with a Wall Street analyst at a very big firm about an upcoming CEF IPO. She had briefly forgotten about my background in finance and must have been thinking of me as another one of the patsies who willingly part with 6% of their investment for no good reason. She was attempting to get me interested in becoming a Day One investor, and I pointed out that many investors know to avoid CEF IPOs and wait for the secondary market price to buy 6% cheaper. Quickly recognizing her mistake, she breezily acknowledged the correctness of my view! Even though her job was to write research that would help persuade investors to overpay for the securities, she understood the fallacy in the message she was pushing.

In fact, it's not dissimilar to the issues that Henry Blodget and others had back in the late 1990s during the dot.com bubble. Blodget, then at Merrill Lynch, was found to have been publicly promoting Internet stocks that he privately acknowledged to be duds. Elliot Spitzer, then New York State attorney general, made his reputation by successfully prosecuting Blodget and his employer Merrill Lynch for not believing what they were saying. Spitzer, of course, later experienced his own reputational undoing with a hooker, but that's another story.

It turns out that Wall Street analysts are supposed to believe what they say in public. Even though this would seem to be obvious, rules were subsequently imposed that require accrediting analysts to add an assertion to any report they issue, stating their belief in what they've written. It is symptomatic of the cynicism of some in the industry that such a rule is necessary. The analyst mentioned above was clearly guilty of not conforming to that rule. In fact, it's hard to understand how any analyst recommending any CEF IPO could truthfully add the “I believe” assertion at the end. They understand the math just described as well as anyone. And they're simply not that dumb to believe that most CEF IPOs are anything other than an opportunity to pay 6% too much.

If you avoid the IPOs, CEFs can offer some interesting opportunities for personal trading. Managing $100 million or more is hard, though not impossible—I know of a few firms that do so. But with anywhere from $100,000 to a few million to invest, along with the ability to devote many hours of analysis, you can find some genuine mispricings. CEFs usually trade at a discount, so you need to assume you'll eventually sell at a discount when buying. Occasionally, activists get involved and press for a stock buyback or even conversion to mutual fund (which eliminates the discount), so being involved in one of those situations can be profitable. Some funds trade at a premium, notably master limited partnership (MLP) CEFs where the tax reporting of a 1099 draws investors who like MLPs but don't like the K-1s that form the tax reporting. Owning MLPs through CEFs is a dreadfully inefficient way to do so unless you're investing relatively small sums and don't wish to do the research necessary to hold individual MLPs.

Yields are commonly misunderstood by investors. If a $100 bank deposit provided you with a $1 quarterly check, even though it was only earning 0.25%, you wouldn't confuse the 4% payout with a 4% yield; you'd recognize that most of the distribution was a return of your own money. Yet CEFs routinely do this, and even though your 1099 will correctly show the composition of your distribution between return of capital and investment return, many investors generally just consider cash returned to them as being the source of the yield. Many non-traded REITs do the same thing, and even though they tell you in the prospectus, the growth in recent years of the market shows the information fails to register with most buyers.

Investors Can Overpay to Simplify Their Taxes

There are several closed-end funds that invest in Master Limited Partnerships (MLPs). MLPs are a great asset class. They are energy infrastructure businesses that run pipelines, storage facilities, gathering and processing assets, transportation and logistics—basically, all the plumbing that moves fossil fuels from where they originate to the final consumer. For many years it was a relatively undiscovered yet lucrative area of the public equity markets. Midstream MLPs (those that operate anywhere between the exploration and production companies that extract oil, gas or coal and the retail distribution) are like toll roads, in that they mostly care about the volumes passing through their system. Although not immune to the economic cycle and commodity prices, they are less sensitive than many other traditional energy businesses.

MLPs are organized as partnerships rather than corporations, which creates some attractive tax deferral features for their investors. The practical result is that in many cases the distributions (which is what MLP dividends are called) are mostly taxed when the investor sells the security. In effect, this pushes away the tax bill into the future which can be as much as a decade or more for buy-and-hold investors. They are the most obvious investment for any reasonably wealthy, tax-paying US investor. Of course there's a catch, which is the dreaded K-1 for tax reporting instead of the far more common 1099. It turns out that getting that tax deferral requires a bit of extra work at tax filing time. This is why MLPs tend to be held by well-heeled investors, because most people need a tax accountant to handle them. Many individuals will not consider investments that fail to provide 1099s.

Back in 2004–2005 I met a very smart young fellow named Gabriel Hammond. “Gabe” had just left Goldman Sachs, where he'd been an MLP analyst. He got me very interested in MLPs as he explained all the operating advantages they possess, and at JPMorgan where at the time I ran a hedge-fund seeding business we decided to finance Gabe's new hedge fund, called Alerian. Gabe was under 30 years old at the time, which was young to be launching a hedge fund. In fact, our first meeting took place at the suggestion of someone else and I was initially quite skeptical that anything would come of it. But Gabe had a well-thought-out business plan that included greatly expanding the universe of potential investors by simplifying the tax reporting. Gabe also recognized the glaring absence of an appropriate benchmark for MLPs, and so he created the Alerian MLP Index, which remains today the most widely used index for its sector.

The tax analysis of limited partnerships and how to recharacterize the income they generate into a form that involved less onerous tax reporting is a fairly obscure area. However, during many months that followed, a substantial amount of expensive legal and tax talent was brought to bear on precisely this issue. The fundamental problem is that a partnership's income has to pass through a corporation and be taxed before it can emerge out the other side as 1099-eligible. You can own MLPs with their tax deferral and deal with a K-1, or you can invest in a corporation (such as a mutual fund), which in turn invests in MLPs and you get a 1099. On its way through the corporation, the income from the MLPs is taxed and you get what's left, around 65%. What everybody wanted was the income from an MLP without the tax filter of a corporation and with a 1099 for simple tax reporting.

Some interesting possibilities were discussed that held the potential to solve this problem, but none of them could ultimately withstand the careful legal and tax analysis to which they were subjected. Perhaps unusually, expensive legal talent was unable to identify a tax loophole. The 1987 Tax Reform Act passed under Ronald Reagan, which created the legal framework for the subsequent development of MLPs, turned out to be secure against tax arbitrage, at least in this case.

The US corporate tax rate is 35%, which is why having the corporation sit in between you and the MLPs leaves you with 65% of the return. For many years, this knowledge was sufficient to stifle the development of any 1099-type MLP investments. I mean, who would seriously give up a third of the return in order to simplify taxes? Surely any investment that has to forgo 35% of its normal return would, as a result, become quite unattractive?

Well, surprisingly, there are a great number of investors for whom 65% of MLPs remains sufficiently attractive to get their money. As a result, a plethora of products has been launched that give you two thirds of MLPs with a 1099 and money flows into them. Striving for the returns of the Alerian Index, my friend Gabe's now ubiquitous benchmark, retail investors buy products that can't possibly achieve the same return, as they make plain in their prospectuses. The biggest of them all is the Alerian MLP ETF, with over $9 billion in assets (ALPS 2015). It routinely underperforms its benchmark (the Alerian MLP Infrastructure Index) by several percentage points, because the benchmark doesn't suffer the 35% tax bite that the ETF does. In theory, the holders could be hundreds of thousands of $10,000 accounts for whom the K-1s are prohibitively expensive. There may even be a case that at this size investment it's a great product, although because of the tax hit its performance has fallen well short of the S&P 500 and REITs (Real Estate Investment Trusts), two plausibly better choices. Or it could be that most investors simply don't understand the issue.

Ron Rowland, a blogger on SeekingAlpha.com, pointed out the tax consequences back in 2010 when AMLP first launched. He's been a tireless critic ever since, during which AMLP has continued its relentless growth. Based on the flows, you might concede that AMLP has been wildly successful and that investors voting with their wallets have decided Rowland is wrong. Alternatively, it may simply show that many investors put far more effort into choosing a fridge than a security (Kennon 2015), as lamented by many including Joshua Kennon, who writes a column aimed at retail investors. AMLP boasts a yield comparable to the index, but then adjusts down its net asset value by the amount of the taxes owed. Just looking at the yield doesn't present the whole story.

Jerry Swank runs Cushing Asset Management and has been investing in MLPs as long as anyone. I once saw him speaking at a conference about the tax inefficiencies of products like AMLP. Not long afterward, he must have concluded that if you can't beat them you might as well join them because his firm launched a similarly tax-inefficient fund.

The HFT Tax

There are quite a few books available on closed-end funds, which aim to educate investors about the pitfalls and opportunities. Yet the market continues to confound those who believe that markets are efficient. The relative illiquidity limits the amount of capital that can be usefully deployed to exploit the inefficiencies, as well as representing an additional source of risk. Many closed-end funds fell far more than the broad equity indices in 2008 as their small market capitalizations and use of leverage caused their discounts to widen sharply.

It's not only for new issues of securities that investors overpay. Although secondary trading in US public equities is superficially incredibly cheap (based on commissions) the high-frequency trading (HFT) trolls take an imperceptible toll on the rest of us. Michael Lewis deserves great credit for explaining in plain English how HFT works in his 2013 book Flash Boys. Lewis is a great writer and I've enjoyed every one of his books. I even read Moneyball. Since I primarily watch English football on TV and have never developed any passion for American sports since moving here from England in 1982, that a baseball book was able to command my attention is about the highest praise I can offer.

Flash Boys illustrated quite elegantly how the current equity market structure and its regulation is several steps behind the abilities of software engineers. Some high-speed trading has its place. Legend has it that Nathan Rothschild learned earlier than most of the English battlefield victory over the French at Waterloo in 1815 and was able to profit through early purchases on UK gilts (government bonds). It's believed to be apocryphal (Kay 2013) but still makes a good story. Speed of information has always been sought.

But some HFT trading is clearly destructive and represents a tax on investors. Imagine you were able to view the electronic routing of orders slowed down by a factor of a thousand, so that you could watch an order travel from New York to Chicago and back in 15 seconds (versus the approximately 15 milliseconds it really takes (Lewis 2013)). You'd see your order leave New York first but then be passed on its way to Chicago by an algorithm-dispatched competing order that had seen your order originate and knew a faster way to reach the cheapest sell order before yours could get there. Lewis memorably describes how Brad Katsuyama, a trader at Royal Bank of Canada in New York, engages in some high-tech sleuthing to figure this out.

Free markets allow innovation, but most of us comprehending the example above would regard it as a sophisticated form of front-running. If a broker buys stock for himself before executing your order, that's illegal. You'd think that designing an algorithm to do the same thing would expose the designer to a similar charge, but life is rarely as simple as it should be. The same desire for speed has led to HFT servers being placed in close physical proximity to the New York Stock Exchange (Trugman 2014) and payment for order flow. This is the odious practice of paying a broker to send its orders to your “dark pool” of liquidity because you deem those orders to be sufficiently poorly handled that taking the other side will be profitable.

The public outcry, regulatory and Congressional hearings that followed Lewis's book may ultimately lead to fixes that help restore some balance and the public's belief in the integrity of financial markets. As with so many of these types of issue though, since it fails the “front page of the New York Times” test, why was it ever taking place? Too many people were facilitating exploitative behavior and modifications required its public exposure. If the victim is invisible to you, harming them seems less morally wrong. It is a consequence of our interconnected world that affords anonymous human interaction.

How is the investor to protect himself? Most obviously is to enter orders into the equity markets that are limit orders. This certainly doesn't shield you from the HFT tax, but it does at least prevent your order from being front-run by an algorithm. If you're not trying to lift an offer in the market, there's no incentive for an HFT program to beat you to it. But you'll still be exploited, as algorithms place orders a penny in front of yours with the objective of buying in front of you and profiting by selling when you increase your bid (which you may). And if the market falls, the HFT will simply turn around and hit your bid for a one-penny loss just as the market drops sharply.

In our business, we are not active traders and have no intention to compete with the speed of HFTs. We simply try and transact our business in a way that at least limits our payment of the HFT tax as far as possible. Most large stocks change price multiple times a second as HFTs compete and probe to identify what the “real-money” investors (i.e., humans) intend to do. It looks like a great deal of price “noise,” and often patience can work. If you pick a price at which you'd like to execute that's close to the current market and simply leave your order there, you will at least represent the most boring type of market participant to the HFTs and the high speed oscillations in price that they cause just might result in you getting done at your price. It's the best defense we can devise for the world we're in. I think that allowing the New York Stock Exchange to become a profit-seeking entity opened the door to the abuses described and possibly many others with little discernible benefit to the rest of us. A stock exchange ought to be run as a public utility. It defies common sense that the current structure of competing pools of liquidity all with a profit motive is really in the common interest.

When Managers Run a Company for Themselves

Public companies are largely run so as to maximize returns for stockholders, but there are of course exceptions. Companies like Enron, Worldcom, and Tyco cost their investors money by committing fraud, and naturally jail terms followed for the perpetrators. Under such circumstances, an equity investor may still conclude that they should have carried out more careful research but such losses can never the less be understandable. But there are some companies who by their actions and public filings make very clear that their objective is to maximize management's compensation at the expense of shareholders. They use full disclosure to stay within the law and go ahead and loot the company. A case in point that we followed some years back is Coeur d'Alene (NYSE:CDE), a silver mining company.

Silver is a fascinating commodity to research. Most silver in the world is mined not directly from silver mines but as a byproduct of other metals such as gold or nickel. Pure silver mines are not the chief source of silver production. Consequently, the supply of silver is more sensitive to the price of the more valuable gold or more abundant nickel with which it's mined. Price moves in silver don't translate into shifts in supply. On the demand side, roughly half the silver consumed is used in “industrial fabrication” (Silver Institute 2015) and it typically represents a very small percentage of the input costs for consumer electronics items such as smartphones (Ferré 2015). Its superior conductivity qualities render substitutes less attractive, and therefore shifts in price don't have much impact on demand, either.

As a result, silver is that unusual commodity for which changes in price have very little impact on demand or supply. Both the production and consumption of silver continue with little response to price. Therefore, small actual shifts in supply or demand, caused by traders for example, result in quite dramatic price fluctuations. It's what attracts traders and speculators, because it can move a lot. Silver's volatility didn't especially draw us to research CDE, but I found the fundamentals of the silver business to be quite interesting.

When we first began researching CDE in 2010, we were attracted to gold and silver miners as a cheap way to invest in precious metals, since some of the miners were available for purchase at less than their net asset value (i.e., less than the value of the reserves they held). As we did further research, we grew concerned that the interests of management and investors weren't as closely aligned as we'd like. By 2012, we'd concluded that such companies were in fact often just a legal transmission mechanism of wealth from investors to management.

There's always a core group of “goldbugs” who believe that ultimately gold and silver will prove to be a better investment than anything else. It's a form of religion, which is to say it's completely immune to contrary evidence such as falling gold prices. Like religion, there's never any point in debating the issue with believers. Faith need never acknowledge facts; there's always more time for the disciple to be proven correct.

I have been writing a blog for several years. I find it a helpful discipline to formulate my thoughts such that they can be read by others. As we concluded that CDE had been a successful management enrichment scheme at the expense of investors, I explained this on my blog and it was published by Seeking Alpha (Lack 2012). I noted the stark contrast between the path followed by the company's stock and the compensation of its longtime CEO Dennis Wheeler (since retired). Unusually, the company's compensation plan rewarded growth in production and not shareholder returns. This would cause any rational CEO (and Dennis Wheeler may have had many faults as a CEO but irrationality was not one of them) to seek growth at any price funded through dilutive equity issuance so as to maximize his incentive compensation. Wheeler had responded splendidly to these misguided incentives, and had further shown his smarts by owning derisively little stock.

The Internet has no barriers to entry for those who wish to write. There is no screening mechanism or quality control unless you limit your reading to well-run websites that review what's posted. Consequently, when you write a story that is critical of a company, you'll quickly stimulate the underemployed to run to its defense. When such criticism is targeted at a precious metals miner, you can quickly observe a virtual crusade of believers rush to defend their faith. It convinced me that no matter how much inefficiency and bad schemes are exposed, there will always be a steady supply of poorly managed capital susceptible to exploitation. Meanwhile, I could write the same story about CDE today, because the current CEO has continued what his predecessor did so ably, to the ongoing cost of investors.

There are plenty of other examples of public companies where management places their interests ahead of the owners. Running your own firm, as I do, creates a wonderful freedom to call things as you see them. It's hard for big financial firms to be openly critical of public companies because they're likely to be seeking to do business with one another.

So Hertz, for example, moved its headquarters from New Jersey to Naples, Florida. As a beleaguered New Jersey taxpayer and a Naples homeowner, I can completely understand the dynamic that renders Florida's zero state income tax highly attractive. However, if you're relocating a global company's HQ to Florida, at least get close to an easily accessible airport such as Orlando, Miami, or Tampa. I can attest that Naples has many attractive qualities, but direct commercial flights to a wide variety of US cities is not among them. It wasn't difficult to find that the (now former) CEO Mark Frissora belonged to a very exclusive Naples golf club, and at the risk of appearing cynical, I suspect that playing nine holes on the way home from work just might have been a consideration.

The Ham Sandwich Test

ADT, the alarm company, embarked on an aggressive share buyback program in 2013 financed with additional debt at the urging of activist hedge fund Corvex, run by Keith Meister. Management was so convinced of the rightness of this effort to return value to shareholders that when Meister suddenly decided little unrealized value was left, he availed himself of the very buyback program he had championed to sell Corvex's stock back to the company in a transaction executed one weekend. The sheer ineptitude of ADT management buying stock from the buyback proponent unsurprisingly caused ADT to drop 30% in the weeks following the release of this information. The reaction was compounded by the subsequent release of weak earnings, advance knowledge of which was held both by Meister and ADT's CEO Naren Gursahaney at the time of ADT's purchase of Corvex's ADT stock. Meister had decided internal management reports showed a deterioration in the business while for some reason Gursahaney, armed with the same information, had interpreted differently. ADT's hapless CEO subsequently defended his humiliation at the hands of a far more wily operator, but it was a hollow and barely credible stance since the original proponent, Corvex, had pivoted 180 degrees by selling into the buyback. Thus it is that the independent money manager unencumbered by any possibility of losing any ADT–related capital markets business can write about the ham sandwich test. This is the admonition of Charlie Munger (of Berkshire Hathaway) that you'd better invest in companies that can be run by a ham sandwich, since one day they most assuredly will. Writing that ADT is clearly taking the ham sandwich test isn't as much fun as making money but it can be a temporarily satisfying diversion.

The lesson for the investor is that when you invest in a company, thereby becoming an owner, assess the management as you would any other agent responsible for managing some of your assets. Expect them to behave as the fiduciary they are and to place your interests first. But don't assume they will, and in such cases it can make sense to rearrange your portfolio accordingly. In the case of Hertz, we regarded the HQ move as one of several major missteps that the many activist hedge funds who also owned the stock would put right by agitating for new management. This duly happened. In the case of ADT, we were less optimistic and voted with our feet.

Activist hedge funds were present in both episodes. By gaining board representation, activists can agitate for all kinds of value-enhancing steps. They can press for improved operating performance, better asset utilization, the sale of underperforming units, stock buybacks, or even putting the company up for sale. By definition, their involvement follows the identification of an undervalued stock combined with ideas on how to correct this. The growing role of activists has certainly commanded the attention of most public company CEOs. Carl Icahn has evolved into a wonderfully pugnacious investor whose website warns, “A lot of people died fighting tyranny. The least I can do is vote against it.” (Shareholders Square Table 2015), drawing on a statement Icahn made at Texaco's annual meeting in 1988.

Although I believe the engagement of an activist is typically positive for the shareholders because of their focus on many value-enhancing moves, investing alongside an activist does constitute a two-edged sword. While a company's management owes its investors a fiduciary obligation, the activist hedge fund isn't similarly obligated (although once they achieve a board seat this can change). Corvex showed how they were able to shift from operating in favor of the public shareholders of ADT to quickly discarding their interests. Not every activist can be relied on to make money for the shareholders of a target company.

If the Prospectus Says You'll Be Ripped Off, It Must Be Legal

Most of the ways investors are unfairly relieved of their money are quite legal and occur in broad daylight. One of the biggest challenges for investors is ensuring an alignment of interests, whether it's in the company whose equity you own or with the financial advisor who is overseeing your portfolio. The most effective way to avoid being blindsided is to confront the Principal-Agent problem. You're the principal; your agent, whether it's a company CEO or advisor, needs to share your financial ups and downs. If they don't own the stock, or invest in what they'd have you buy, you're in a weaker position to ensure your best interests are foremost.

When investors overpay for a security, accept outrageous fees or align themselves with unscrupulous management bent on self-enrichment, how much of the blame lies with the investors themselves? The analysis in this book is largely drawn from public sources, and while it's true that the authors are all finance professionals, the information is available for those with the time and willingness to do the research. One problem is that it's so time consuming. Take the prospectus for a typical non-traded REIT. The basic document can easily run to 200 pages and then there are supplements of additional information that can add much more. Non-traded REITs provide abundant information about their planned operations that reveal just how costly they will be. For example, the Phillips Edison ARC Grocery Center REIT II, Inc. (November 25, 2013) consists of 250 numbered pages plus probably another 50 of appendices.

The front cover shows that the initial fees are 10% of proceeds. Page 14 reveals further “Other Organization Expenses” of 2%. But the list goes on from there. Although you might think that buying properties is the basic business of a REIT, they'll charge a 1% acquisition fee. If they reach their target leverage of 75%, $100 invested will eventually buy $175 of properties generating $1.75 in fees, or 1.75% of your invested amount. Other expenses related to buying properties can add up to 0.65% of their value or a further 1% of the invested amount. This all adds up to 14.75% of your initial investment.

The REIT manager receives additional shares equal to 1% of the value of the REIT annually. It reimburses affiliate expenses at up to 2% annually. There's a 0.75% payment for organizing financing; 4.5% of monthly gross receipts in property management fees; leasing and construction management fees (not determinable in the prospectus). There's a 15% share of the profits that goes to the manager and a further 15% share of the increase in value if the REIT goes public.

There are also 13 pages devoted to conflicts of interest. All the people involved in the REIT have other demands on their time. But they also benefit from fees paid to service providers, fees that, “…have not been negotiated at arm's length.” The prospectus notes that the dealer manager, otherwise known as the underwriter, is not independent of the REIT. We know the firm recommending the investment isn't objective because it is receiving so much in fees, but in addition, it is not independent of the REIT, further compromising its advice. The firm managing the properties is also an affiliate. And the value of the portfolio is not arrived at independently, but by the REIT manager.

It's all there in the prospectus, and frankly, an acceptable investment return to the retail buyers after all these fees and conflicts is nothing short of miraculous. There's no way that an advisor with a fiduciary obligation to a client could possibly recommend such an investment. And they don't. Non-traded REITs are sold on the basis of suitability and disclosure. Clearly, suitability is a far lower standard than a fiduciary one since this is all going on perfectly legally. And there is obviously disclosure since I've just recounted all the fees, relying on a public document.

But is there understanding? Do the buyers truly comprehend what they're getting into? My friend Penelope in Chapter 1 most certainly did not. If an abundance of information is provided such that digesting it requires the same effort as reading a very dry book, was any information really provided? If you poll finance types about non-traded REITs, it doesn't take long before you find people acknowledging that they're an accident waiting to happen. In fact, I've found extremely few people who understand the product with anything other than a highly negative, cynical view. Suppose a minority of doctors was prescribing medication known to be harmful? Would the rest remain silent? There would (or most certainly, should) be all kinds of consequences. There would be public criticism and debate. Our industry needs to take greater collective responsibility for its overall behavior. I don't believe I have any friends who are making a living from these toxic instruments, but I'm willing to risk acquaintance with a few people in order to expose utterly self-seeking actions by those who traffic in them. Others shouldn't be so afraid to criticize.

Individual investors (and often institutions, too) commit enormous errors of omission and commission in their use of financial services. At the most fundamental level, finance as a percentage of GDP roughly doubled from 1980 to 2007 without any commensurate increase in social welfare (defined as median real household income or net worth). At a more granular level, countless examples exist of investment products being bought that create far more value for the broker than the client; of investors behaving more as gamblers than investors; of only the most cursory review of important disclosures in documents. The free market most definitely provides the products and services people want, but it also provides what they ought not to want if more thoughtfully considered. When you assess how efficiently capitalism produces countless successful products that are truly worthwhile, why hasn't finance done a better job? Why doesn't it live to a higher standard?

Timing Is Everything

The single most sought-after advice must be timing. Of all the activities in which consumers engage, and especially all the purchase decisions, rarely do they have to consider whether what they're committing their funds to will benefit from opportune timing. Even the purchase of a house, the most analogous decision to making personal investment decisions, is driven as much by need and the availability of financial resources as it is by an assessment of the real estate market's near-term direction.

It's understandable, because before and after the moment of making an investment, it's easy to recalculate how different it might have been if bought yesterday or a month later. It's the most common question I'm asked in an infinite variety of forms. Like everyone else, I follow the market's direction. But much as I'd like to hold a strong, correct opinion on its next move, years of experience have taught me that over the short run it's almost impossible to do much better than chance.

Yet money managers, banks, and brokerage firms routinely imply that they have some methodology that will help you get the timing right. They use econometric models, proprietary tools, and even (perish the thought) technical analysis. Charting, the divining of patterns in past market actions so as to forecast future swings, has been around as long as anybody can remember. Although there are a small minority of purists who make their market decisions solely based on technical analysis, most investment professionals use a wide range of fundamental and technical tools. Personally, I'm skeptical that letting any pattern of past performance drive today's investment decision is going to make you wealthy. But charts do tell a story far more elegantly than a table of daily closing prices and so they're useful in that fashion.

One investor I know will solemnly note that the chart for a particular stock his investment committee is considering “looks great” or “looks bad.” What it reveals is that he's a momentum investor. Although not all chartists are trend followers, trends show up most easily on a chart, and a stock that's been falling is not going to attract trend followers to buy it—or many people at all, which is why it's falling. I always chuckle to myself when I hear this guy's opinion, because if you're an investor you're generally trying to buy while other people are selling. You absolutely want the chart to look bad; you want to be buying from the short-term, technically driven traders since as soon as the selling is exhausted they'll quickly turn around and make the chart look good.

Overall, it's a form of alchemy. In finance, those whose entire view of a security is formed by its chart pattern are regarded somewhat quizzically by their colleagues. There is, of course, no reason for it to work. I've always thought the possible basis for it was as a visual representation of behavioral biases that investors hold collectively. Momentum investing, which is a form of trend following, has been shown to be a source of long-term returns, reflecting the comfort we humans derive from buying what our peers are buying since it confirms our beliefs. On its own, it's an insufficient tool, but occasionally and in conjunction with other forms of analysis (such as examining financial statements) it can help, or at least feel as if it helps. Because that's just the problem: if charts represent one part of a decision-making process, it's mighty difficult to figure out just how important they were to the decision. Since they might have helped, in some unquantifiable way, you ignore technical analysis at your peril. Although I've never read a definitive research paper showing that technical analysis produces reliably attractive returns, its adherents are many and passionate.

I remember one technician (for this is what they're called, evoking the notion of insight into the market's wiring) whose daily prognostications could often be summed up by stating that if it goes up it'll keep going up, and if it starts falling it'll keep falling. He sounded very knowledgeable while he was saying this, and often published specific trade recommendations. Such forecasts bask in the luxury of not being burdened with the requirement to actually make money. The business model is one of popularity—if a sufficient number of people are interested in the technician's views, the name exposure his firm receives as a result justifies the compensation expense he represents.

I once had a foreign exchange trader who worked for me who was an unabashed chartist. He truly believed that all the information you needed was reflected in the past history of a currency. Now it's true there can be less to consider in trading currencies than individual equities, since at least for developed country currencies it's typically not necessary to pore over their financial statements every quarter. And in my experience, currencies do exhibit sustainable trends more reliably than, say, bonds or commodities. Imbalances caused by, for example, interest rate differentials that favor one currency over another (by making it more profitable to invest in the higher-yielding one) can persist for years. Of course, another appeal of charting can be that it provides a convenient excuse to avoid having to analyze financial statements or other fundamental data. Technical analysts take their work seriously and apply themselves to it diligently, but it's also possible for a part-time technician to do his market analysis in ten minutes over coffee and a bagel. This can create the false illusion of being a very efficient worker.

The FX trader I mentioned was quite happy to engage in an experiment whereby he did the trades recommended by our in-house market technician. Both shared the same commitment to charts as an under-appreciated path to market success, a belief clearly at odds with the in-house technician's avoidance of trading any actual positions so as to provide empirical proof of his insights with trading profits. When challenged, he invariably countered that managing trading positions would challenge his objectivity, as if holding a losing position would induce him to continue recommending it in spite of the chart's contrary insight. But then, why hold a losing position if it's not what the chart said? I always found debating such tortured logic a brief but entertaining use of time when lining up to get lunch in the trader's cafeteria.

To the surprise of my FX trader if not to me, the technical analysis trading account was unprofitable. In explaining the result, my Kool-Aid drinking trader even accepted partial responsibility for at times misinterpreting the very information he was analyzing. It was along the lines of that he ought to have recognized the type of pattern that was evolving but stupidly interpreted the wrong shape. It was almost as if the results were not the result of the faulty religion but of the less than completely faithful practice of one of its adherents. So what use to a profit-oriented trading room is a fully committed chartist who can't be trusted even to follow the charts? At this stage I must confess that we had found ourselves in this position as a last-ditch effort on my part to salvage some profitability out of a trader I'd hired who had to this point been consistently losing money. His own market views expressed in the form of trading positions had been singularly unprofitable, so all that remained was to see how he did with somebody else's views. The experiment wasn't just intended to provide a “live ammunition” record of our in-house technician's market insights, it was my last best effort to prove that my recent hiring decision hadn't been a bad one. Sadly, his failure confirmed my earlier one and I had to fire him. All was not lost though, because he was able to transfer his unsuccessful experience as a proprietary trader into a new business advising clients on their hedge fund investments.

In trading, timing is everything because of the use of leverage. Whether it's explicit leverage through the use of borrowed money to finance assets or implicit leverage through the use of off-balance-sheet instruments such as derivatives, once you introduce leverage you care about the path a security takes on its way from here to there. While I can't claim to have anticipated the 2008 crisis and the collapse in equity markets, I did at least organize my affairs with sufficient conservatism (meaning no debt) that I never faced any financial pressure to sell. For me, the failure of Lehman and subsequent nadir of markets saw me glumly contemplate paper losses that I believed must ultimately recover, but by pondering my worst-plausible outcome long before we got there I avoided being hostage to events way beyond anybody's control.

The huge advantage an investor has over a trader is that the investor has the luxury of time whereas a trader may not. Warren Buffett, source of endless wonderful quotes and sage advice, often counsels that investing with borrowed money is a dumb idea. Now one can point out that Berkshire's use of its insurance “float” to invest in stocks amounts to the same thing, and Buffett himself often notes that he loves the insurance business because people pay you to hold their money. He means that insurance premiums paid by customers earn no immediate return and only have to be paid for in the future through insurance claims. But putting aside this advantageous business model that has worked for decades, for millions of individual investors it remains sound advice to limit your exposure to what you actually possess and not increase it with borrowings.

The same thing is true for leveraged companies. The more cyclical their business, the less debt they should have so that a sudden downturn doesn't see the equity holders wiped out in favor of the bondholders.

While investors using just their own money aren't as vulnerable to poorly timing the market, they quite reasonably care as much as anybody else about buying at a good time.