Wall Street Potholes. Simon А. Lack

that if a chosen equity index such as the Russell 2000 returns 10 % during the time period that the private equity investor held his investments, he would expect to have earned 13 % to 15 % or more. Otherwise, the choice of private equity was not worth the risk compared to its more liquid publicly traded equivalent.

      There's a saying on Wall Street that certain investments are sold, not bought, in that they require a salesman to push them on a willing investor rather than the buyer actively seeking them out. This would certainly apply to non-traded REITS. Because the first question any investor, or for that matter well-intentioned advisor, should ask before considering non-traded REITs is how the sector is likely to perform going forward. Asset allocation, the choice of how much an investor should put in stocks, investment grade bonds, REITs, high-yield bonds, commodities, or any other asset class generally drives 80 % to 90 % of the investor's overall return. In other words, assuming you hold a reasonably diversified portfolio and don't bet heavily on just a few investments, if stocks are up 10 % you should be up by a similar amount. Of course it's a generalization, but the point is that the biggest decision an investor makes is how much to allocate to an asset class.

      So before even considering an individual non-traded REIT, you need to consider how the sector is likely to perform and how this compares with the other assets available to you. This is how institutional investors start their investment process. Given the limited amount of data available for non-traded REITs and the unsophisticated investor base, it's unlikely this basic question receives any attention. It also means that investors are unlikely to properly evaluate the performance of a non-traded REIT once they've bought it. Unless you're in finance for a living, comparing results with a benchmark won't come naturally.

      The Importance of Benchmarking

      Non-benchmarked returns are great for the broker, though. You'd think that because numbers are the very essence of investing, they'd be used in discussing performance. It's really quite incredible how often results are presented without comparison to the alternative choice, or the relevant benchmark. A 5 % return can only be evaluated if you can compare it with what else you could have done with your money. In the case of non-traded REITs, the upfront fees and ongoing expenses represent a substantial impediment to outperforming or even matching any relevant benchmark. That's why the results are not usually compared with anything. Brokers love nothing more than to use adjectives rather than numbers to characterize the results they've achieved for their clients. It's so much easier to tell a client they were “up 7 %, which was good.” However, if the investment has lost money, the advisor may well resort to a comparison with a benchmark, such as, “you were down 9 % which wasn't bad considering equities were down 11 %.” It may or may not be a valid comparison. A balanced account with 50/50 stocks and bonds shouldn't be compared simply with equities.

      Clients should always ask how a strategy will be evaluated. It's as simple as asking at the beginning of the relationship, “What should we both look at in order to correctly evaluate the performance of my account once you're managing it?” Ideally, it should be compared with a relevant benchmark. An equity strategy should be compared with the S&P 500 if the underlying stocks are large cap US equities. The Russell 2000 might be more appropriate if smaller stocks will predominate. A fixed-income strategy should be compared with a bond index, such as the Barclays Aggregate Index. It should be possible to agree on an index at the outset. If the advisor is any good, he shouldn't mind having his performance benchmarked. Many will try to argue that their strategy doesn't fit easily against a benchmark, or that a previously agreed benchmark is not relevant “for this type of market.” As the client, your response should be simple. Tell the advisor that if we can't agree on how to evaluate you, we'll never know if you're doing a good job. And if we can't tell how you're doing, why are we bothering with you in the first place?

      Obfuscation of performance is the mediocre financial advisor's friend. Non-traded REITs are the perfect product for a salesperson who doesn't want to be evaluated other than on the fees he generates. There's no accepted benchmark and hardly any investment research. These factors work against the interests of the client.

      Puts and Calls

      Recently, I was asked by a new client to evaluate an IRA that was being managed by his former advisor. It included a selection of dividend-paying stocks combined with some options positions. Many people like what are called “covered call” strategies, in which they write call options on stocks they already own with a strike price above current market levels. It's often described as a way to generate additional income through earning option premium, and if the stock that's owned does get called away well, it'll be at a price at which you were in any case happy to sell.

      There are a couple of problems with this. One is that if you own XYZ stock and you write a call option against it, you have created the exact same position as if you had simply sold a put option. It's called “put-call conversion.” Like a mathematical equation, the profit/loss on your covered call trade can be shown to be identical to that of a simple, short put option with the same strike price and expiry as the call option. Although a covered call strategy doesn't sound that risky, many people would find shorting put options to be very risky. You've got all the downside associated with owning the stock, and have only limited upside. I've run interest rate options trading in the past, ranging from plain vanilla to complex and exotic options. Exploiting put–call conversions to manage risk was one of the basic elements in our toolkit, and this remains so for today's options traders.