The Florida Bar

A NEW PERSPECTIVE TO THE INVESTMENT WORLD FROM AN INVESTOR’S RIGHTS ATTORNEY: PART 2 – AVOIDING “BAD-FIT” INVESTMENT STRATEGIES

May 28, 2021

By Chris Vernon

Part one of this three-part series, A New Perspective to the Investment World from an Investor’s Rights Attorney, focused on application of a system to determine whether you (or your clients) need to work with an investment professional and, if so, how to avoid working with an investment professional who is not good or not a good fit. Part two follows a similar path with investments: A system to help you avoid investments and strategies that are not a good fit for you (or your clients). Read about the companion CLE presentation held June 9, 2021.


As we did in part one, we start with the quote from self-proclaimed “philosopher,” pretty good actor (and possible candidate in the Texas governor’s race) Matthew McConaughey:

“Process of elimination is the first step to our identity (aka where you are NOT is as important as where you are).”

I propose an investment approach that is similar to the one discussed in part one for finding the right investment professional: start with objectively identifying what you (and your clients) don’t want or need and, based on that determination, seek out strategies and products that avoid those situations. This approach will help you define how you should invest to meet your wants and needs (and your client’s wants and needs) rather than allowing the wants and needs of the investment professional and the financial industry to define how you invest. To this end, set out below are a number of products and strategies that most mature investors should avoid in crafting a map to control their own financial destiny.

Overconcentration Mistakes

Most competent and ethical financial professionals should (and do) use the words allocation and diversification in talking with clients. Similarly, most savvy long-term investors intentionally apply some version of allocation and diversification unless they are intentionally speculating. Proper allocation and diversification avoids overconcentrating in a particular asset class, industry, or stock (i.e. avoids speculating on a particular asset class, industry, or stock that can lead to big losses if you bet wrong). As a result, these are good terms for you not only to understand, but also to implement when determining how to manage your overall financial health.

The term “allocation” refers to how your money should be allocated (or distributed) among the different classes of assets. For example, how should your money be allocated among asset classes such as stocks (aka equities), bonds (aka fixed income), real estate, commodities (e.g., gold), foreign investments, and cash?

Although often used interchangeably with the term “allocation,” the term “diversification” actually refers to investing in diverse products within the available asset classes like the ones listed above.

Implementing allocation and diversification is a two-step process: first, determine your allocation (i.e., what asset classes you want to invest in and how much in each asset class); and second, implement diversification (i.e., buy diverse products within each asset class).

The opposite of allocating and diversifying would be to invest in one asset class and/or to concentrate in one investment in each asset class. For example, if you invest all your money in one asset class such as gold, or put your entire bond allocation in one corporate bond, then you are speculating rather than implementing the concepts of allocation and diversification. Speculating can make you rich, but can also make your money disappear very fast.

Unfortunately, less competent and less ethical investment professionals fail to adequately look beyond your brokerage account when advising you on allocation and diversification. In other words, these concepts of allocation and diversification should be applied to your overall financial health and not just your brokerage account. Here is an example of how overall allocation and diversification might come into play: if you are a real estate agent/broker and your income is based on the real estate market through buying and selling (and possibly owning/renting for yourself), then your financial advisor should not allocate much (if any) of your stock and bond portfolio to real estate-related companies because you are already heavily concentrated in real estate.

Leverage and Margin Mistakes

Outside of home ownership, borrowing money is typically not viewed as a good financial decision. Yet Wall Street uses terms for borrowing that make it sound much more sophisticated and positive; words like “margin” and “leverage.” Despite the fancy terminology, leverage and margin are forms of debt and they can devastate your investment portfolio.

When “margin” is used to invest and the returns are less than the interest rate on the borrowed money or, worse yet, if the underlying investment materially declines in value, then dramatic and unrecoverable losses can quickly occur. As a result, we recommend you avoid margin (unless you are speculating with your portfolio), especially given the political turmoil, social unrest, national debt situation as well as the rise in stock and real estate prices.

Although borrowing money (aka “margin”) to invest sounds like a fairly simple concept to avoid, “leverage” can be used in more subtle and complex ways in the investment world that are often inadequately explained and inadequately disclosed to you in terms of risk. This typically involves the recommendation of an investment product that internally uses significant leverage to achieve the suggested returns. From my perspective, this type of “leverage” can make a relatively conservative strategy risky and, in some cases, can result in unintentional speculation. Although the use of leverage is widespread within investment products, examples of the heavy use of “leverage” to achieve returns would be futures contracts, some oil and gas investments, and most non-traded REITs.

And, in some cases, we see recommendations by “investment professionals” to use “margin” to invest in products that use “leverage” within the investment. The problem with this type of situation (which we sometimes refer to as double leverage) is that when the investment and/or the markets turn against you, the losses mount extremely fast, but the amount owed does not change. This can lead to your entire investment being lost and, in some cases, leave you with more debt to pay even after your investments are gone.

In sum, unless you are intentionally speculating, avoid margin and also avoid heavily investing in instruments or products that are dependent on significant leverage to deliver the anticipated returns.

Illiquidity Mistakes

There are many types of risks to be considered when investing. One risk that is often not considered is the risk that the investment is not “liquid” at the time of purchase, as well as the risk that the investment might become “illiquid” after you invest. Essentially, this “liquidity risk” is the risk you take that the investment cannot be sold on short notice without a significant penalty or discount to market value. Our law firm often refers to this as the “Hotel California” effect: “You can check out any time you like, but you can never leave.”

Liquidity risk is significant in many “alternative” investments, which broadly refers to investments other than what we know as traditional assets like publicly traded stocks and bonds. Alternative investments can include products such as hedge funds, private equity, EB-5 investments, private offerings, non-traded REITs, structured products, etc. Liquidity risk can also indirectly exist with packaged products and funds that seem more conventional and appear very liquid when you buy them, but a significant disruption in the markets or the economy can force these funds to sell their underlying assets into an illiquid market at distressed prices to generate cash to redeem investors who want to exit. This can cause permanent damage to your investment.

Unfortunately, liquidity risks are often disclosed only in lengthy, small print documents that investment professionals pass off as boilerplate language. While it is unrealistic to read these lengthy documents in full, there is typically a section entitled “RISKS” that is a reasonably short subsection of the document. If you focus your reading on the risk section, it will often disclose some of the biggest risks of the investments, including liquidity risks.

Here is a sampling of what you might see in the liquidity risk section of an offering document of a product that appears to be very liquid when you buy it: “The secondary markets have experienced periods of illiquidity and can be expected to do so in the future. Limited Liquidity may result in delays in liquidations or lower returns.” If you see this, it is a red flag, and you should not listen to your financial advisor if he or she claims, “that never happens.”

Annuity Mistakes

Annuities are one of several products that are over sold to investors over 50-years-old, often with the pitch that it allows market participation and protects against big market losses. The 2008 crisis fueled this sales pitch and, if the markets correct again, it will likely fuel sales of these products even further. However, from our perspective, these products have a lot of downsides and are often sold by commission-driven salespeople with limited competence as investment professionals.

This entire article could be about annuities because they are complex products with a variety of differences for each type. However, regardless of the type, most are touted as having guarantees, tax benefits, upside participation, downside protection, and other characteristics that make them sound especially appealing to conservative investors. Because these products are usually sold by commission-based salespeople (although more lower commission products are now being offered), the many downsides of annuities are often not adequately discussed by the “professional” recommending the annuity.

Most investors don’t realize or don’t consider the material fact that an annuity is actually a contract between you and the insurance company. In other words, the insurance company is not just the transfer agent, but actually created this product and plans to make money from it if you buy it. This may seem very basic, but many annuity purchasers don’t think through the reality that the insurance company is on the other side of the contract table and is offering this annuity not because it is the best investment for you, but because it is a moneymaker for the insurance company.

As mentioned above, another downside of most annuities is that the insurance company will pay your trusted annuity agent a very big commission if he or she convinces you to buy the annuity. While a lot of annuity salespeople brag about the fact that the investor doesn’t have to pay them anything, I view this as a negative for the investor. Specifically, if you are entering into a contract, it is not a good idea to have the person advising you to be paid by the party on the other side of the contract (i.e., the insurance company).

These downsides create significant conflicts of interest for both the “advisor” recommending the annuity and the insurance company issuing the annuity. As a result, I recommend independent due diligence and a second or even third opinion before investing in an annuity.

This independent due diligence is especially important due to the fact that most annuities have significant financial penalties if you change your mind and want to liquidate it within the first few years (although some newer low commission annuities do not have this penalty). This liquidation penalty can put investors in the difficult position of losing significant principal to liquidate the annuity or being stuck in an annuity they no longer want. And the real reason the insurance companies charge this penalty is to recoup the big commission they paid the “advisor” who recommended the annuity.

Structured Note Mistakes

Billions of dollars of structured products are sold by the securities industry every year to conservative retail investors. These products are grossly oversold and often riddled with conflicts of interests. But, candidly, many investors love them without understanding them, so the industry finds them easy to sell.

According to Wikipedia, a structured product is “a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives.” As you can see by the very definition, these are complex investments.

Despite the overall complexity of these investments, they are built on a very simple and troubling platform. Specifically, at their core, many structured products involve you (the investor) loaning money to your own brokerage firm or financial institution (based on the firm’s recommendation) on an unsecured basis. Essentially, this means that you have limited recourse if they fail to repay you. To make matters worse, structured products typically have no liquid market like stocks or bonds where you can buy or sell them at a market price prior to maturity.

Structured products were originally a custom-designed product to fit the needs of a specific institutional investor. However, Wall Street firms and big banks then figured out how to make massive amounts of money by packaging and selling these products on an assembly line basis to their own retail customers, with a side benefit of converting their own client base into a lending facility (i.e., borrowing money from their own clients at terms far superior to the terms required by institutional lenders).

In summary, if you bought a structured product from your financial advisor, it is likely that: (1) you actually loaned money to the firm where your advisor works; (2) your loan is not secured by any collateral; (3) you are effectively stuck with it until it matures; and (4) the firm on which you are relying for investment advice has a massive conflict of interest in that it is the counterparty to your loan.

These structured notes have very sophisticated names, so you may not even realize they are being recommended to you. Thus, make sure you ask whether the investment product that is being recommended to you is a structured note.

Gold and Precious Metals Mistakes

Some investment professionals and economists have been sounding the alarm on the economy. When (and if) these concerns grow and get picked up by the mainstream media, investors often look to gold and other precious metals to weather the storm. However, as investor’s rights attorneys, we have concerns over many of the “professionals” selling gold, especially the ones that advertise on the radio or on television (including ones that use celebrities to pitch what they are selling). From my perspective, many of these companies are unethical, and investors should be especially careful when investing in gold or other precious metals.

If you decide you want to allocate a portion of your portfolio to investments in gold or other precious metals, avoid the television and radio pitches and consider precious metal related exchange-traded funds (ETFs) or even precious metal mining stocks or do significant due diligence to find a competent and ethical gold and precious metal dealer.

Although objective consumer information on buying gold is hard to come by, due in part to lack of uniformity in the product and lack of regulatory and/or consumer watchdog oversight, here are some basics to get started with your investigation of buying physical gold to possess:

Decide if you want gold coins (numismatic coins) or bullion or want to invest in the gold or precious metal industry;

  • Find a trusted and independent source to access current prices of the precious metal you want to buy as a benchmark for what you should be paying to buy it;
  • Read independent articles by authors who are not connected to a seller to learn about what you plan to buy before purchasing it; and
  • Limit the amount you invest unless you are intentionally speculating (because the precious metals markets can be extremely volatile and the markets for buying and selling physical gold can be inefficient).

Non-traded Real Estate Investment Trust Mistakes

A REIT is a Real Estate Investment Trust. Many REITs are bought and sold daily on stock exchanges. However, this warning is a recommendation to avoid Non-Traded REITs, which are a large subset of REITs that are not bought and sold daily on an exchange. It is rare that we make a blanket recommendation to avoid a product or strategy, but we believe it is warranted in this case.

The deceptive “pitch” is that Non-Traded REITs avoid stock market volatility and provide access to big real estate properties, with tax benefits and steady income at a higher rate than many income products on the market today. However, we emphasize the word “pitch” because big commissions for selling Non-Traded REITs motivate incompetent and unethical “financial advisors” to grossly oversell these products.

Here are some of our concerns regarding Non-Traded REITs:

  • Many REITs are considered “public” because of required public regulatory filings, but calling them public does not mean they can be bought and sold on a stock exchange;
  • When you add other front-end fees to the high commissions, initial fees and costs can be in the range of 15%. This means only 85% of your money is available to invest and the Non-Traded REIT would have to increase in value by 17% just to break even with your money;
  • It can be hard to sell a Non-Traded REIT if it runs into problems. This is analogous to having a stock you can sell unless it goes down in value, in which case you are stuck with it as it stops paying dividends and continues to collapse;
  • Non-Traded REITs often purchase much of the real estate in the portfolio after they get your money. In other words, you are in some ways investing blind and trusting them not to overpay for properties or otherwise make bad buying decisions with your money; and
  • Early distributions paid out to you after you invest can include (or even be completely composed of) borrowed funds and return of the investors’ own money, and payouts may actually exceed the cash flow of the REIT.

If you are considering a Non-Traded REIT, we recommend reading each risk factor in the risk section of the offering document and seek a second opinion. If you already own a Non-Traded REIT, we recommend you have it independently evaluated to determine if you should redeem it before it is too late.

Commercial Real Estate Mistakes

COVID-19 hit commercial real estate hard. Real estate that depends on foot traffic, such as gyms, hotels, retail stores, and restaurants suffered, while work-from-home arrangements by corporate America continue to leave office spaces empty around the country. For investors, the financial concern is the likelihood of a permanent shift in how companies are approaching buying, leasing, and using spaces.

Companies such as Amazon (AMZN) show retailers around the world that e-commerce is the future of retail, while companies such as Zoom (ZM) suggest that remote work is the future of the workplace in corporate America. As a result of these trends and COVID-19 as an accelerant, the rents generated by many commercial real estate properties could drop below mortgage costs, maintenance costs, and taxes. Although it appears that interest rates will remain low in the short term, interest rate hikes could make it even more difficult to cover the cost of owning commercial real estate. This could create a domino effect wherein owners cannot pay lenders. Collectively, the foregoing is likely to drive down the value of commercial real estate.

As an investor, you should keep in mind that many commercial real estate investments, including many REITS, are structured in such a way that early distributions and lack of accurate valuations can initially conceal problems with these investments. As a result, don’t be fooled by a pitch that the commercial real estate investment is currently performing as marketed. Most importantly, do not fall prey to a pitch that you now have an opportunity for direct access to commercial real estate investment opportunities that were previously only available to institutional investors. Institutional investors are now frantically looking to unload their commercial real estate and are willing to pay significant commissions to salespeople who are willing to tell you that this is a great opportunity.

Focus on what you independently know about commercial real estate before falling victim to these sales pitches. Be wary of investing in commercial real estate unless and until it begins to sell at significantly distressed prices.

Cryptocurrency Mistakes

Cryptocurrency investing involves many layers of risks. We understand the appeal of investing in cryptocurrency such as Bitcoin and Ethereum, but that appeal should not blind you to the significant risks involved in cryptocurrency investing.

Our firm has seen a recent influx of calls from investors who have been ripped off in cryptocurrency scams. From our perspective, these scams are nothing more than the recycling of traditional scams that use cryptocurrency as the new hook. Cryptocurrency scams are popular now because most everyone has heard a story of someone getting rich from cryptocurrency in the last several years. This certainly makes the scam more believable in the eyes of a victim.

We recommend the following steps to protect yourself from and minimize the chances of getting burned by a cryptocurrency scam:

Research. Do research to determine how you want to invest in cryptocurrency. For example, do you want to invest in an ICO (initial coin offering) as opposed to the secondary market? Do you want to invest directly in a cryptocurrency or invest through an exchange with an ETF or fund of cryptocurrencies? Each carries its own level and type of risks. Thus, you should answer these questions before you consider any sales pitch.

Conduct independent due diligence. If you do have an interest in investing based on a random cryptocurrency sales pitch (which we discourage), conduct independent due diligence research (not reliant on the representations of the salesperson or promotor) to determine whether there is anything suspicious about the investment or those pitching the investment. Independently research the promotors, the custodian, and the strategy involved; don’t let the salespeople and promotors explain away the red flags you find.

Be aware of the unique risks. Consider that even legitimate cryptocurrency investments carry unique risks not found in more traditional investments, including a greater risk of cybertheft, lack of regulation, lack of government support, lack of existence separate from the blockchain technology, storage risks, risks that much cryptocurrency ownership is highly concentrated, and limited use as a currency.

Remember the traditional risks. And, keep in mind that beyond the unique risks of cryptocurrency, the traditional risks of investing in an obscure currency exists when you invest in cryptocurrency, including significant price volatility, potential lack of liquidity, and virtually all other traditional investment risks.

Oil and Gas Investment Mistakes

Oil prices fluctuate wildly, whether you look at the price of a barrel of oil over the last 50 years, 20 years, 10 years, or this year. This high fluctuation in price (known as volatility) means oil has been a high-risk investment for decades. In other words, the high risk of investing in energy is nothing new. This is true regardless of whether you adjust prices for inflation. Additionally, you should know that the inflation-adjusted price of a barrel of oil today is about the same as it was 50 years ago. This suggests that many investors are not being rewarded very well for the significant risks they are taking while investing in oil.

As a result of the foregoing, investing in oil-related investments such as Master Limited Partnerships (MLPs), energy-related Business Development Companies (BDCs), and other energy-related investments can be (and often is) speculative.

Nevertheless, we regularly see portfolios in which “financial professionals” have overpromoted and oversold MLPs, energy-related BDCs, and other oil and gas investments to investors during boom times. This is often the result of these “financial professionals” downplaying, ignoring, and/or concealing the risks involved with energy-related investments when recommending them. Investors should also be aware that many of these energy-related products are underwritten (i.e., pushed onto the retail market) by the same financial firms that are recommending them. This is a conflict of interest that is often overlooked.

Given the history of oil prices, it is troubling that these same “financial professionals” act shocked by volatility in the energy markets that result in outsized losses for their clients.

If you experienced significant losses due to over-concentrations in MLPs or other oil related and energy-related investments and your investment professional asserts that the outsized losses were unforeseeable, we recommend you replace your investment professional. And, if energy prices begin to stabilize or rise in the short term, be careful of any “financial professional” who promotes investment in oil and gas as a conservative, tax-advantaged, income opportunity.

Conclusion

By avoiding the products and strategies outlined above, you (and your clients) will reduce the risk of having your financial security stripped away during the last half of your life. And, if you avoid the unethical and incompetent financial advisors (outlined in part 1 of this series) as well as avoid the products and strategies outlined above, I believe the chances of a devastating financial loss to your investment portfolio will be reduced dramatically.

“Remember, whatever it is, let’s make sure our money is working for us and not for somebody else.”

ABOUT THE AUTHOR

Chris Vernon is a Naples-based financial litigator who represents investors in financial disputes throughout the United States. He holds an AV rating by Martindale-Hubbell, has been recognized by Florida Super Lawyers and The Best Lawyers in America every year for the past decade. He is also licensed as a Registered Investment Advisor and has testified as an expert on both investment matters and FINRA arbitration matters