The challenge for the nontraded REITs industry during the Department of Labor fiduciary rule hearings: mount a reputational defense.
An early version of the rule did not include nontraded REITs among the products that could be included in retirement accounts.
A number of nontraded REIT sellers, such as LPL Financial, braced for the worst, while on Capitol Hill, advocacy groups such as the Alternative and Direct Investment Securities Association debated the need for such products, and pushed back against the relentless focus on low-cost.
John Harrison, executive director and CEO of ADISA, and John Grady, president-elect, spoke with Money Management Executive on the group’s efforts during the fiduciary rule hearing, and the effect it has had on alternative products. Both men acknowledge the difficulty arguing a case before a department following at times a preconceived notion of how these products work.
What follows is an edited version of the discussion.
What have been concerns from both the adviser perspective and the product supplier perspective regarding nontraded products, especially in light of the DoL fiduciary rule?
Grady: We did submit a comment letter. We really took a two-fold approach. We said that the sponsors in the original rule proposal of nontraded products were left out of the exemption.
That was important because, for one, there was no real meaningful reason given why, other than that they chose a more liquid suite of products to focus on as far as eligibility [for retirement plans]. We focused on why that would be, in effect, denying to long-term investors the products most closely designed for long-term hold.
To deny retirement accounts the ability to diversify non-correlated assets into investments in their portfolios, we thought, was really a step in the wrong direction. So, we advocated strongly for the inclusion of nontraded products of any stripe. But we focused on nontraded REITs, BDCs and oil and gas programs, because let’s face it, that’s the lion’s share of the direct investment market.
The second part of what we talked about was that, not withstanding their denial, the Department of Labor was taking a position on which business model was more effective from their standpoint — from an investor protection and investor results standpoint. They clearly believe that what they call conflicted advice, which is the broker-dealer commission or transactional model, was yielding less-positive results for investors. We didn’t think they had a lot of data for it, but it did seem like a wholesale attack on the business models.
We made it very clear that we didn’t think that the attack was warranted, and to the extent that they needed a rule at all that advocated for a business model they needed to leave plenty of room for multiple business models under that rule, including the commission-based model. That meant that the exemption had to function, and it was not functional when it was proposed.
It seems the DoL was able to tap into the public perception that financial advice is overpriced and not working to benefit investors.
Grady: I think some aspects of what advisers are selling are incapable of being reduced to a cost.
An adviser’s ability to counsel their client, to not react to news, to take a longer term view on investing even when they have short-term needs that would otherwise cause them to consume their retirement savings are all things advisers can do that have nothing to do with product and nothing to do with the cost and expense of an investment, but rather to do with encouraging behavior or recommending behavior to clients.
In the long run, whether they use particular products from an outcome standpoint, I think the hardest thing to remember is the outcomes are less certain than the debate has assumed. There’s almost been a sense in the DoL discussion that, ‘We know what certain products will do, and therefore we know that someone recommends them because they’re an expensive product, because of compensation, not because of outcome,’ as if we know that active management will trail index funds. Over periods of time they do, and over other periods of time they don’t. I think we are arguing for a diversity of approaches that allows for choice.
Advisers who are looking at a high cost, nontraded REIT, or another investment that you would lump in the alternative category; if they don’t see anything about the benefits of non-correlation and diversification and they just see costs, they say something like, “Why would I own that? I really should own an index fund. Vanguard tells me it’s what I keep and not what I spend and maybe I should do that?”
There’s a lot of wisdom in that philosophy that Vanguard puts out there, but that’s not the economics that apply to alternatives.
For us to get lumped into a cost discussion, and for all conflicted advice to be lumped into compensation related rather than outcome related, was hard for us to see because it kind of damns us at the beginning, by saying, “As soon as you have an outcome that could change by which security you recommend, and therefore you know the bad ones and the good ones ahead of time, supposedly, and just go ahead and recommend the bad ones because they pay you more,”
I think there’s a level of crystal ball thinking in that, that doesn’t exist in the real world, but it’s a brilliant way how the department framed the debate.
Would you say the DoL plugged into the investor trend to invest in passive funds and even robos?
Harrison: We can talk about the volatility and we can talk about the risk factor of herd behavior, and you have got to magnify it by several orders of magnitude when you do that.
That’s the model that Sweden has.
If you look at 1999 and go to 2009, let’s look at Vanguard and their index funds, and you compare it with Harvard Endowment. I think if you can compare those two models you will find something along the lines of 0% for Vanguard after fees, and you will find about 135% for the endowment model, which is heavily invested in alternatives.
We can philosophize on this thing a lot; however the results indicate that well-managed funds do better. You can make the same argument with medicine; we need to have machines do everything because if you look at those studies, the machine does a better job at diagnosing you than a physician, but who wants to go to a machine instead of a physician?
Do you feel like the industry is too concerned about public perception to provide your organization the type of support for products that you are advocating, and that’s one of the results this rule and maybe a lasting effect?
Grady: I think that there are others who had wrestled with some of the cheap beta arguments that are there: ‘Why would you ever pay for something when you can get it for less through an index fund or an ETF?’ whereas what we’re saying is, we’re talking about assets that are hard to acquire, hard to select, difficult to manage, and require expertise in how you sell them or even how you value them.
We are willing to make the argument that alternatives are not going to be a cheap beta substitute. They are going to be, in fact, the diversifier and not the core component. Does that give us the advantage of saying in that argument that there is no alternative that is sitting there that’s obvious and cheap the way that an index fund is, and therefore the active manager might concede that someone might fall to an ETF and not lose anything. With our products, there really isn’t.
There might be funds that try to chase the same returns using derivatives, but then they get into a whole host of different issues as to how well they can track the results that they’re trying to provide, or whether even the SEC wants them to be in funds that they do, or the leverage that’s entailed.
We went this by saying, “We can see a clear benefit to the true alternative investment in a client portfolio that already owns stocks and bonds; you can see the diversifying elements, you can see the non-correlating elements help in both risk and return management. With that as a starting point, therefore we’re arguing, why would you exclude them? And ultimately the Department did back off and allow the full spectrum.
The best interest contract exemption is designed to focus on the conflict and make the adviser work hard to acknowledge it and mitigate it; even in fact represent that the conflict didn’t control the outcome, but rather the quality of the investment was the determinant.
So we said, “If they are sold with a comission structure, the BIC exempetion model has to work well enough to allow that result. It can’t just be something that every investment fails if it has a commission.” If that’s the case, you have really taken certain kinds of investments out of the hands of retirement investors.
I appreciate your point that there are parts of our industry that are struggling to demonstrate why they are more expensive but a valuable alternative to some of the products that are less expensive and more machine-oriented, or index-oriented. I don’t think that we fall into that trap because of the unique nature of the underlying asset.
It’s not a security, it’s a piece of real estate, it’s a business loan, it’s an oil and gas program, it’s an equipment lease; that’s where we are seeing a lot of the non-correlation benefits.
I think we can stand up and say, “We have developed a way of selling these products that is focused on a commission.” So, the industry has taken advantage of this dialogue to say, “Maybe we can design products that do fit in an asset based account where there’s a fee charged and no distribution cost.
No one had ever called for it, and if they had, they hadn’t to shown up to buy it when it was built. I think the industry is going back to the drawing board and saying, “If we build it, then we are going to be building products with a different distribution structure.”
The Department of Labor dialogue actually helped us ask the question, “Why do we have the commission structures we do? Why do our products tend to skew toward frontend compensation?” We use this dialogue as a chance to ask that question to a lot of our members.