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Wall Street’s “Black Box” Investments For Retail Customers

November 21, 2016 Blog

If a merchant is having difficulty selling a product, they sometimes wrap it up in a fancy black box with a bright red ribbon on top and then sell it to an unsuspecting customer.

That seems to be the case with the latest fad investment called “interval funds” which Wall Street asset managers are dumping into unsuspecting customer portfolios.

Never heard of an interval fund? Well, they operate under the same rules as mutual funds but are named such, because, while investors can buy them daily, they can only be sold in limited amounts at specific intervals, usually at the end of the three month quarter that marks a fund’s calendar.

When you can’t cash out of a fund the day after it’s purchased, buyer beware. That lack of liquidity spells danger for Mom and Pop investors. Just ask the thousands whose brokers sold them non-tradable real estate investment trusts in 2006 and 2007, right before the mortgage crash. Investors’ money was trapped and the values of many REITs plummeted. Clients simply couldn’t sell the nontraded REITs and reinvest elsewhere. Many of those REITs caused devastating losses in retirement portfolios.

Because interval funds are registered like mutual funds, they are not subject to recent brokerage industry rule changes that have absolutely devastated the sales of nontraded REITs and other illiquid investments.

With high commissions to brokers of 5% to 6%, sales of interval funds are booming. Over the first nine months of the year, money managers registered to sell $26.7 billion, up 24% from the same period in 2015, according to a recent column by Jason Zweig for the Wall Street Journal.

“This peculiar vehicle is called an interval fund, and asset managers are using it to offer portfolios they might not be able to market otherwise,” Zweig notes. “While such funds come with an admirable focus on holding assets for the long term, they also lock money up in ways many investors aren’t accustomed to”. (Emphasis added)

The interval funds hold very sophisticated and potentially volatile investments, according to Zweig. They  include “commercial real estate, timberland and farmland, online consumer loans, the debt of distressed or bankrupt companies, ‘catastrophe bonds’ that are tied to risks like hurricanes or earthquakes, and other illiquid positions that seldom trade in the financial markets.”

It is highly unlikely that investors understand the products that are being marketed to them, and it’s just as unlikely that their brokers understand them well enough to explain the risks of interval funds adequately.

Indeed, because interval funds specialize in less-liquid assets, they “could face greater challenges than typical mutual funds in valuing their portfolio holdings,” according to a lawyer quoted by Zweig in his column.

In other words, when your broker hauls out this new type of fund that is hard to understand and difficult to sell, stay away.

After new Securities and Exchange Commission members are appointed in the months following the recent presidential election, they need to focus on opaque, complex, investment black boxes like interval funds being pedaled to clients. Investors need to understand what they are buying and brokers need to understand what they are selling. Again, buyer beware.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.