How To Select A Financial Advisor: The Least You Should Know (Part 22 In eBook Series)

How To Select A Financial Advisor: The Least You Should Know (Part 22 In eBook Series)

Chapter 22: CONCLUSION

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Thank you for taking the time to read this book. It is designed to help you develop a relationship with an investment advisor that puts you on an equal footing.

If you don’t know what to expect from your advisor, then you will be unable to direct him to fulfill your needs. You must come prepared with an understanding of what your advisor can do for you, as well as what he is legally obligated to do for you. Don’t be afraid to ask questions—or to ask them again if you don’t understand the answer.

RECOMMENDED READING


Bonds Now! Making Money in the New Fixed Income Landscape
by Marilyn Cohen and Chris Malburg, John Wiley & Sons, Inc.,
New York

Fooled by Randomness by Nassim Nicholas Taleb
Random House, New York

Investing–Starting from Scratch by Janet Holt
Eakin Press, Waco, Texas

The Little Book of Common Sense Investing by John C. Bogle
John Wiley & Sons, Inc., New York

The Most Important Thing by Howard Marks
Columbia Business School Publishing

The New Coffeehouse Investor by Bill Schultheis
Portfolio, a member of Penguin Group (USA), Inc.

The Only Investment Guide You’ll Ever Need by Andrew Tobias
Harcourt, Inc., Orlando

The Random Walk Guide to Investing by Burton G. Malkiel
W.W. Norton & Company, New York

Your Money and Your Brain by Jason Zweig
Simon & Schuster, New York

Goldman flap underscores fiduciary issue
by Darla Mercado • InvestmentNews, Vol. 16, No. 12
Copyright (c) 2012, Crain Communications, Inc. All rights reserved.

When midlevel Goldman Sachs executive Greg Smith blasted his firm publicly for what he deems is rapacious behavior toward corporate and institutional clients, many retail advisers whose résumés include wirehouse stints nodded in recognition.

His New York Times Op-Ed piece struck an emotional chord with many of them who recalled relentless sales pressure.

“During the last 30 days that I worked at a brokerage firm, I received 25 e-mails from my branch manager on why every one of my clients needed to have [some] new proprietary mutual fund,” said Bob Rall, a Fee-Only adviser at Rall Capital Management and a veteran of Prudential Securities Inc.

“Everything was about the YTB on the product—the yield to the broker—not the yield to the client,” he said.

WAKE-UP CALL

Russell G. Thornton, a vice president at Wealthcare Capital Management Inc. and a Merrill Lynch alumnus, agrees.
“Within the commission and sales environment of the wirehouse world, the general operating principle is: ‘How can I sell the most stuff to my clients?’ ” he said.

Although Mr. Smith’s frame of reference reflects the institutional market, some advisers hope that his Op-Ed will be a wake-up call for clients, getting them to demand better quality of service they receive from advisers.

“One thing this … will certainly do is make the idea of a client-first duty of care harder to ignore,” said Michael Branham, an adviser at Cornerstone Wealth Advisors Inc. and 2012 president-elect of the Financial Planning Association.

“Regardless of your legal obligation, it makes business sense to put the client’s interests first,” he said. “Whether it’s [The Goldman Sachs Group Inc.] or a small independent broker-dealer, that’s what clients are really asking for.”

Some of the media coverage declared that advisers true loyalties to themselves and their firms, not their clients.

“A blazing resignation at Goldman Sachs shows us once again that financial advisers too often put their own interests first,” blared a sub-headline in an article posted last week on Time magazine’s website.

Some advisers think that they are far enough from Wall Street so that the Op-Ed won’t spur clients to question their commitment.
But others said that all the attention the Op-Ed generated only made a stronger case for highlighting the distinction between advice from a fiduciary and product information from a sales representative. If anything, it gives the public a hint of the battle brewing in Washington over from whom a fiduciary standard of care should be required.

CLIENT LOYALTY

“I think clients want to know that whoever is working with them has their interests at heart, and that there’s more loyalty to the client than to the firm,” said Susan John, chairwoman of the National Association of Personal Financial Advisors.

“In the world of Greg Smith, the affected clients are institutional and presumed sophisticated—they should know and understand the rules of the game,” said William L. McCollum, a portfolio manager and chief compliance officer at Eagle Financial Management Services LLC.

“To the retail client, the revelation of conflicts of interest may come as a surprise: They have been misled to believe that their interests come first, when in most cases, there exists no fiduciary relationship,” he said.

“These firms and their representatives should not pretend to be something they are not,” Mr. McCollum said.

But other advisers think that the basic tenet of doing what is best for the client transcends business models. In other words, Fee-Only service arrangements are the only way to do right by the customer, because bad apples can turn up among those advisers, as well.

“The whole fiduciary thing has been blown out of proportion, and ultimately it boils down to trusting someone,” said Mr. Thornton, who describes his Fee-Only business model as “not better, but different” from his previous commission-based work.

“There were people I didn’t like and didn’t trust at Merrill, but I also know Fee-Only people who I don’t trust or understand. Bernie Madoff should have been a fiduciary, and he was the worst.” Mr. Thornton said.

“If you do what’s best for the client, you still make money—but that’s long-term, as opposed to short-term,” said Rick Peterbok, chief executive of Interactive Financial Advisors, a dually-registered firm. “If you do more to help the client, the rest will be OK.”

APPENDIX B

Chaos Over a Plunging Note
Complex Security Drops 60% in Value in Just Three Days; SEC Is on the Case by Tom Lauricella, Jean Eaglesham and Chris Dieterich
Copyright (c) 2012, Dow Jones & Company, Inc. All Rights Reserved.

Regulators are examining a complex exchange-traded note after volatile trading in the securities over the past week caused a 60% drop in value in just three days.

The Securities and Exchange Commission is looking into the VelocityShares 2x Long VIX Short Term Exchange note, sponsored by Credit Suisse Group AG, according to people familiar with the matter. The review, which could include trading and disclosures, is preliminary, the people said.

The scrutiny comes amid rising investor alarm and confusion over trading in exchange-traded notes. The Credit Suisse note, which trades as TVIX and is designed to track stock-market volatility, plunged 29% on Thursday last week and then another 29% the next day, even though market volatility was little changed. Another exchange-traded note, a Barclays Capital product designed to track natural gas, plunged this week for reasons that investors say remain unclear.

Spokeswomen for Credit Suisse and Barclays declined to comment.
Market observers say the confusion underscores the deceptively risky nature of exchange-traded notes. While hedge funds are usually the most active traders of the securities, the notes have become more popular with smaller investors, in part because they are low cost and easy to trade.

But what looks like a plain-vanilla instrument can be treacherous, said Samuel Lee, an analyst at Morningstar Inc. who follows exchange-traded investments. “It’s an issue of financial innovation opening up these esoteric markets and allowing individual investors pile into them faster than the regulators can keep up,” Mr. Lee said.
Another type of security, exchange-traded funds, have exploded in popularity for similar reasons.

On the surface, exchange-traded notes, widely known as ETNs, appear similar to exchange-traded funds, which trade like stocks on an exchange. But the inner workings of ETNs are more complicated. An ETN doesn’t actually hold any underlying investment as an exchange-traded fund, or ETF, would. Instead, an ETN is contractual agreement by the issuer to pay shareholders returns equal to the investments it is designed to track.

Adding to complexity of this situation, the Credit Suisse ETN is linked to the Chicago Board Options Exchange Volatility Index, or VIX. That index, which is based on options prices, can experience wild swings. The Credit Suisse ETN is designed to magnify that volatility; investors make or lose twice as much as the daily move in the VIX.

Similar “leveraged” products have been the subject of scrutiny before. During late 2008 and again last summer, they were blamed by some for fueling late-day swings in stock prices.
Industry participants say the troubles in the Credit Suisse offering started as it approached $700 billion in assets and became too big for the market it was trying to track. Then, as the bank scrambled to manage the problem, it set off a chain of events that led to the price collapse.

The Credit Suisse ETN more than quadrupled in size this year. Meanwhile, the leveraged aspect of the fund required it to rebalance its portfolio at the close of trading each day based on moves in the VIX. Because traders knew that, they could profit by buying or selling before the fund, pushing prices higher and costing the bank more. Also, traders speculate Credit Suisse may have had internal limits on how much it could buy.

On Feb. 21, Credit Suisse suspended issuance of the ETN’s shares “due to internal limits on the size of ETNs.” The announcement carried a warning that the move “may cause an imbalance of supply and demand” in the ETN’s shares.

But some investors continued to buy the now-limited shares of the fund, driving up the share price even as the VIX itself was falling. As a result, there was a steadily widening gap between the share price and its net asset value based on the level of the VIX.

On March 21, shares of the ETN closed at $14.43, 89% higher than its $7.62 net asset value, according FactSet Research.

Hedge funds and other sophisticated traders saw an opportunity and began aggressively betting the shares would decline. After the halt, the number of the ETN’s shares borrowed by short sellers nearly quadrupled overnight, from nearly 600,000 on Feb. 21 to about 2.2 million a day later, according to Data Explorers. By March 22, the number of shares borrowed had jumped to 4.1 million.

But individual investors such as Eric Brehm, owner of a medical-supply distribution business in Sunnyvale, Texas, were in the dark. On Feb. 22, he had bought 2,200 of the shares for $17.30 each. it “was a way to hedge if the market took a big drop and offset my losses in other securities,” the 59-year-old Mr. Brehm said.

Seemingly out of nowhere on March 22, the share price for the ETN went into a free fall, losing 29% on its way down to $10.20. That evening, Credit Suisse announced it would issue new shares of the ETN on a limited basis, raising eyebrows among traders who wondered if word of the move leaked out. Over the next two days it would fall further, closing at $5.88 on March 26.
—Ben Levisohn contributed to this article.

“A blindfolded monkey throwing darts
at a newspaper’s financial pages
could select a portfolio that would do
as well as one carefully selected by experts.”
~Burton Malkeil, American economist and writer

 

Nontraded REITs need more regulation
Editorial, InvestmentNews

Copyright (c) 2012, Crain Communications, Inc. All rights reserved.
Given the barrage of negative publicity surrounding nontraded real estate investment trusts, broker-dealers and REIT sponsors have a vested interest in working closely with regulators to improve investors’ understanding of the value and performance of nontraded REITs.

If they don’t, they’re likely to find themselves saddled with regulations that are cumbersome, costly and, most importantly, even more confusing than those that exist today.

Broker-dealers and REIT sponsors need to step up their efforts to develop industry-accepted standards for formulating asset valuations and to hold brokers more accountable for making sure nontraded REITs are suitable for the clients to whom they are recommending them.

RISKY FOR SENIORS

Regulators are right to set their sights on the nontraded-REIT industry. As sales of nontraded REITs have grown—no doubt thanks to the volatility of the stock markets and the low-interest-rate environment—so, too, has the number of investors, many of them seniors, who have found themselves blindsided by plunging share values or inadequate disclosure related to the illiquidity of their investments.

In an article appearing last week in InvestmentNews, news editor Bruce Kelly profiled the plight investor Susan Fox, who watched the value of nontraded-REIT shares in her IRA plummet. One of those REITs—Cornerstone Core Properties REIT Inc.—recently disclosed that its share value had dropped 72% to $2.25, from $8. In the story, Ms. Fox, 63, alleged that her broker invested too much of her retirement savings in nontraded REITs and that she was not made aware of the inherent illiquidity of those shares.

Ms. Fox is hardly alone. Last May, the Financial Industry Regulatory Authority Inc. accused David Lerner Associates Inc. of selling shares of its real estate funds to elderly and unsophisticated clients.
Clearly, more regulation is warranted. On March 7, Finra issued a revised proposal to amend NASD Rule 2340 to address the “per-share estimated values” at which unlisted direct-participation programs, including nontraded REITs, are reported on customer account statements.

Under the revised proposal, broker-dealers no longer would be required to provide investors with a per-share estimated value, unless and until the issuer provided an appraised value of the shares in a periodic report filed under the Securities and Exchange Act of 1934. During a nontraded REIT initial-offering period, broker-dealers would have the option of representing the security as “not priced” or presenting investors with a net offering price minus the broker’s upfront commissions.

The public-comment period for that proposed rule change ends April 11. If enacted, the rule change would improve investor protection in two ways. First, it would shine light on the high upfront broker commissions for selling REITs. Those commissions, which often range from 10% to 15%, inevitably would fall—decreasing the incentive for brokers to sell unsuitable nontraded REITs.
Additionally, the rule change would help eliminate investor confusion about the value of REIT shares during their IPO period—and, in some instances, well beyond that.

In and of themselves, nontraded REITs are neither “good” nor “bad”; they’re simply investment vehicles that are suited to some investors, but not to most.

Have a question? Contact Ed Mahaffy.

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