Terra Extraneus

Investment News reported on the federal sentencing of a college student for 3 and ½ years to do and a restitutionary fine of $4.18 million for collecting investments for a non-existent hedge fund. His mother helped him and she was sentenced to two years for wire fraud. Her defense was that her son made her do it. The kid pulled it off posing as a wealthy Turkish heir.

This type of thing happens every day in America. The more typical scenario is that a fledgling and usually floundering company is obtained in a reverse merger with a shell public company. The public shell is usually owned or managed by an entrepreneurial sort and the fledgling start up company is usually desperately and unsuccessfully searching for venture capital. The fledgling start up company could be a company with a new technology it is trying to bring to market, or more likely, it is an idea in search of a metamorphosis from dream to reality. In either case, the company usually has no capital or is very thinly capitalized, cannot quite make a case to venture capitalists, but now has shareholders that either need an exit strategy or are unwilling to wait until the idea matures into product.

In these situations, it is difficult to separate the pump and dump schemes from the legitimate search for capital. This problem is not limited to penny stocks sold on the bulletin board, but happens all over the market. It is nothing to see, as it was at the beginning of the decade and is once again, an internet company with few hard assets valued at hundreds of dollars per share while a company with billions of dollars in assets, like a bank or insurance company, is valued at share prices in the tens of dollars. The “market” is often not rational.

When trying to determine whether the investment is bona fide, common sense is the first line of defense. If the proposed product sounds impossible, it probably is impossible under present technology. Does the company merely have a good idea in search of a way to reach this plane of reality, or is there a real plan to bring the idea to concreteness and then to market? While it is true many of today’s financial titans started in somebody’s garage just a few decades ago, the question is, what is keeping this company in the garage? If the company, or the person promoting the stock, cannot or will not disclose the reason mainline venture capitalists are not interested, then it is unlikely the company can or will disclose the truth about much else, especially to stock purchasing investors.

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Regulation D exempts certain securities investment vehicles from registration with the government and generally permits the existence of some types of non-public securities owned by a handful of strangers. Typically, to invest in an unregistered security, the investor must be qualified. One of the ways they must be qualified is by being an “accredited investor.” An “accredited investor” is an investor that has assets that can be invested and that are valued at $1 million or more net of home ownership or earns more than $200,000 per year.

The SEC is reportedly considering revising the definition of “accredited investor” to make it applicable to hedge funds and to define qualification for hedge funds to include a minimum net worth of $2.5 million.

While this makes some sense, it does not go far enough. The reason the SEC is considering this is because the “suitability” requirements, which impose limits on the risk to which an investor can be exposed by a registered representative, do not apply to hedge funds which accept investors directly rather through a broker dealer. In order to make the “accredited investor” definition look like a suitability requirement, it should make the net worth threshold exclude not only the family home, but it should also exclude IRAs, 401(k)s, and other retirement vehicles like SEPs and life insurance cash value. It should also be limited to persons with at least ten years of investing experience with equities, or commodities, or options.

Eventually, some hedge funds will evolve into main stream investment vehicles that will have some sort of short form registration and will be offered by broker dealers. The suitability rules and the drive toward true diversification that motivates the best registered representatives will provide adequate protection. Until that day comes, the customer that would otherwise be served by a retail registered representative or broker dealer should not be in hedge funds. An updated definition for accredited investors will fill part of the gap for the rest.

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It happened again. An 85 year old man came to see me. He had been sold a variable annuity when he was 79 that carried substantial surrender charges and only a death benefit for security. The person that sold it to him was not a registered representative, but some sort of insurance agent with only a series 6 licensure, and little understanding of risk. His life savings was placed into aggressive funds. A third of his savings was lost in the crash of 2001 and in the intervening years, because of a failure to monitor his investments or provide the ongoing review that he thought he was buying from the major national insurer that sold the variable annuity, his investments have recovered less than 20% of the loss suffered in 2001. Money doubles every seven years except in variable annuities that are steeped in too much risk and too little common sense. If after the crash someone had just suggested moving his investments to a balanced fund within the same family of funds already in the variable annuity, he would by now be nearly back to where he started.

Investment News reported that the state regulator for Massachusetts, William F. Galvin, has proposed a set of criteria for variable annuity sales to elderly. Other states, the article reports, like Nebraska, are considering rules.

If suitability rules already on the books are not enforced, new sales practices rules will not add much. Moreover, sales practice rules are not enough to protect the elderly, or anyone, if the issuers of variable annuities are not also held to the same standard as wirehouse registered representatives and supervisors. They are required to review account positions at least annually and make recommendations. State regulators should also have on their websites a list of things for customers to demand and one of those things should be an annual review of positions in every account. If variable annuity issuers are not going to provide this, regardless of the reason, then these products must be clearly labeled as “self-directed” accounts after they are sold and advising the purchaser to obtain a financial advisor to review positions annually. Also, companies that do not offer annual position reviews should be precluded from imposing surrender charges beyond the first year on any variable product. Multi-year surrender charge platforms should be precluded for anyone over the age of 70.

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The NASD, according to the magazine On Wall Street, has brought 280 disciplinary actions in the last five years. Recently, an NASD arbitration panel awarded $22 million to 32 chemical plant workers employed by ExxonMobil. Thus, it seems that variable annuities have been the tool of fraud in a small number of cases. Because there are over a trillion dollars in variable annuities, I truthfully conclude abuses are limited.

Oddly enough, one of the better critiques of consumer investment vehicles I’ve seen is in a magazine distributed solely to financial industry professionals, On Wall Street. But, the article is freely available on line. Every non-professional investor, and maybe a few registered representatives, should read this article. The National Association of Securities Dealers, Inc. also has lots of investor advice for free regarding annuities and it should be consulted for updated warnings before any purchase.

So, what is this all about? In the last decade or so, the alliance of insurance products and securities has added some tools to the array available to financial planners and financial products salesmen. One of these is the old family of products known as the annuity, but the updated versions of this product include the variable annuity and the index annuity. An annuity was an insurance product by which an investor deposited a lump sum or series of lump sums with an insurance company. The insurance company then promised to pay, regardless of future economics, on a monthly, quarterly or some other basis a stream of income, typically for the life of the investor and/or the investor’s spouse. It was a great thrift vehicle and a great guaranteed return. But, the explosion of wealth in the US, and its parallel explosion of value in the equity (stocks and bonds) markets out stripped the return on investment offered in annuities.

The variable annuity updated the concept by relying on equity market performance rather than insurance company performance. The money invested is, mostly, invested in mutual funds that in turn invest in stocks, bonds, and other financial products. The variable annuity holds the underlying investments on a tax deferred basis, and can even wrap the investment in life insurance that prevents heirs from inheriting less than invested even if market losses reduce the value of the annuity investments.

But, there are abuses, and investors should know about them so that intelligent investment decisions can be made, and so that a valuable tool, like variable annuities, need not be over regulated or abandoned.

The problem with insurance products generally, and variable annuities specifically, is that the expenses, fees and hidden costs (hidden to consumers, at least) are sometimes too high to allow the annuity to earn enough over time to compete with other products. A few financial advisors are too tempted by the high commissions these products pay to use the products only when the costs are justified. Also, these products suffer from historical insurance industry baggage, such as the refusal of the insurance company to spend the money to supervise the sales forces that sell these products, and that lack of oversight is expressed in lengthy and high surrender charges which deter customers from waking up, exiting the product and leaving the insurance carrier to recover the commissions paid to the salesman.

The worst problem is that the insurance industry and the securities industry, which are both by law charged with the duty to supervise the salesmen, do not always monitor the underlying investments in the variable annuities. So, there is too little account rebalancing, risk monitoring, or review of the performance to identify mutual funds that are no longer suitable for the portfolio. Also, many investors think the salesman that sold them the annuity has some special expertise, some do and some do not, and that the salesman is monitoring the underlying investments. Unfortunately, while most do monitor their clients’ investments, too many do not, and the losses arising from that small percentage of salesmen, that group that are not really financial advisors, is large enough to create regulatory concern and media interest. It has employed a few lawyers, too.

Indeed, the article in On Wall Street recites that the arbitration award in favor of the chemical workers, noted above, was largely based on the finding that the broker –dealer did not have in place a system to monitor the securities trading in the underlying accounts within the variable annuities. Given that many of the customers are elderly, retirees and nearly all of them are unsophisticated investors, the absence of monitoring of the securities investments in the underlying accounts within the variable annuities is unforgivable. The lack of transparency in costs is regrettable, too. Long surrender periods should not be imposed on anyone already aged more than 55 or 60 years, and commissions on products sold to older persons should be adjusted accordingly. The insurance industry will no doubt adopt a bunch of form admissions for the hapless consumer to sign but that is not enough protection, and they know it. Sadly, because the tort system has been largely gutted, the insurance industry and the securities industry will only address these problems if forced to do so by regulatory agencies.

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Money magazine, published by Time, Inc., is a bit of a mixed bag. Its articles offering financial analysis range from simplistic to difficult and sometimes indecipherable, and mixed in are articles full of nothing but pop nonsense. Sometimes Money fills space with some of the strangest ideas.

In the July issue the magazine ran nearly two pages, an enormous article by Money’s standards, on “How to Pick an Advisor Who Connects with You.” The article manages to address that subject without discussing qualifications, training or infrastructure.

Instead, Money suggests picking a financial advisor by matching your temperament and “knowing what you want.” The article quotes psychotherapists, psychology professors, and other academics, and asserts that financial advisors come in discernible profiles: teachers, commanders, the “brain,” the grandfather, the “best friend,” the “scold,” and the “coach.”

Has Money never heard the phrase, the “blind leading the blind?”

A financial advisor should be selected by assessing the same things that would be considered in picking a doctor or mechanic: education, training and experience. Also, financial advisors should have credentials that match the level of needed sophistication in planning and advice. The ability to communicate complicated financial principles and the risks of products is usually related to education, training and experience.

The problem most unsophisticated investors have is that they cannot tell the difference between a qualified financial advisor and a salesperson with a good line. What investors should be taught by Money is how to tell the difference. One important factor is the size and quality of the financial organization supporting the financial advisor. There are many broker-dealers who are on the fringe of net capital qualification to do business. In other words, the value of the company is barely enough for the broker-dealer to be considered a going concern by regulators. Those firms should be avoided at all costs by the financially illiterate. They are too hungry.

Every investor should have a Certified Public Accountant to act as a backstop. Two hundred dollars (Oklahoma rates) of a CPA’s time once a year, had it been expended, would have prevented nearly every loss suffered by every investor I’ve seen who then had to seek relief through litigation.

Every investor should have a financial advisor, in addition to a CPA. The advisor preferably has a degree in finance, or many years of experience in the securities industry, or both. Some investors will be happy with financial advisors who are employed by large institutions, such as banks and large broker-dealers, while others will be happy with those in small shops (and by small, I mean the size of the company, not the size of the shop the investor visits).

The recommendations of the financial advisor, checked by the CPA, should fit the investor. There are thousands of financial products in existence, and most investors should avoid the new, the unconventional, or the exotic. Yes, there are some investors who can afford to be exposed to higher risk, but most cannot.

One key way to tell whether a financial advisor is interested in the investor or the sale is how he explains risk. If an investor is encouraged to describe himself as a “moderate” risk investor, that investor actually is being encouraged to accept losses, G-d forbid they should ever occur, of up to half of principal. Most investors, if asked directly if they would accept the unlikely loss of half of their principal, will respond with a resounding “No.” A true “financial advisor” knows this as well or better than I do. But a salesperson simply does not care, because risk-of-loss discussions take up time which could be used making the next sale.

Some investors might be willing to be “moderate” investors as to some portion of their holdings. Some might even be willing with some percentage of their holdings to risk a total loss of principal, in other words, to be a speculator or high-risk investor. 10%-20% is as far as most investors are willing to go in accepting “moderate” or “high” risk, but almost every investor I’ve ever met had their entire portfolio tagged as “moderate” risk, when the investor would have wisely refused that label had he known its true meaning.

A financial advisor will not try to involve the investor in a savings program that takes more of the investor’s cash flow than the investor is comfortable saving. In the Money article, the recommendations ranged from “all you can save” to a “third of your pay.” Younger or older, saving is a matter of disciplined spending and disciplined investing. But turning the discipline into some sort of death march does not result in greater returns; for most people it makes quitting and failure inevitable. The financial advisor who can train investors in the discipline of incremental saving and investing is better than the financial advisor interested only in the sale, who recommends a crash course that everyone knows will be quickly abandoned.

A good financial advisor also will not hesitate to recommend investment strategies and products, even if the financial advisor might not benefit much from the recommendation. If the investor has plenty of insurance, plenty of equity market investment, and needs to diversify into real estate or other products, the financial advisor will not hesitate to say so.

While annuities may lack the returns of the equity markets, they likewise are less subject to market volatility. I have met many older persons, often in their late 70s or 80s, who would have been much better off with an annuity than a NASDAQ stock, mutual fund and market volatility. Money growing slower than inflation is still not lost in a single market downturn and a monthly payout is a living. Many younger people should still consider whole or universal life insurance because it is a disciplined savings vehicle, and not because it provides the greatest returns.

But Money, which often lacks a penchant for “tough love” financial advice and abandons the hard truths in favor of “happy words,” worries me when it seems bound to send investors off hunting for the “coach,” the “scold,” or other pop psychology categories of financial advisors, without first mentioning qualifications, financial stability and professional licensing and designations.

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The Dow Jones Industrial Average closed at 11,011.90 on Monday — the first time the Dow has exceeded 11,000 since 2001. The Dow broke 11,000 for the first time ever in 1999, and hit its record high of 11,722.98 on Jan. 14, 2000, but plummeted when the tech bubble burst, and was further depressed by 9/11 (2001). The Dow is an index of 30 of the largest public companies. Here’s the NYT report.

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