From the June 2005 issue of Investment Advisor • Subscribe!

A Brief History of Bad Advice

It really doesn't matter what Santayana said, if you don't know what to do with your knowledge of the past

Harvard philosophy professor George Santayana famously said: "Those who cannot remember the past are condemned to repeat it." Well, maybe. But I've found that, like many quotations, Professor Santayana's dictum sounds like it makes more sense than it really does. The problem is that the mere knowledge of past events doesn't afford us any particular insight into the lessons of history.

For instance, it's not clear in the current public debate whether the "lessons" of the Vietnam War suggest that we shouldn't have gotten involved in Iraq in the first place, or that once our troops were committed, continued public opposition only encourages the enemy. In this debate, both sides claim WWII "lessons" by citing either a Neville Chamberlain-like appeasement approach by the U.N. toward Saddam Hussein, or by claiming that George W. is the real Hitler now. In our own universe, many students of financial history still lost their keisters in the dot-com crash despite their extensive knowledge of manic markets from Dutch tulips to Japanese yen.

So while I try to avoid commenting on other writers' work (honest, I do), recent tail-wagging in this magazine (see "The Road Less Traveled" in the May 2005 issue) and others over the "new" interest in alternative investments has driven me to reconsider. It seems to me that a brief recap of some of the "lessons" we've learned in the short history of financial planning might be appropriate. You might have guessed that I'm referring to my perennial whipping boy, limited partnerships.

To avoid another learned correction from my friend Ken Ziesenheim of Thornburg, let's just stipulate up front that out of the thousands of public and private limited partnerships sold by financial planners during the 1970s and '80s, a few actually did work out for their investors. In any event, quite a few more didn't work out so well, KOing several Wall Street houses--Bache Securities, EF Hutton, and Thompson McKinnon come to mind--as well as giving a decade-long black eye to the planning profession.

Now we're hearing that with the stock market back to churning out reasonable returns, investors/clients are clamoring for vehicles that promise the steroid-induced kind of returns we saw in Bill Clinton's 1990s (can stocks play major league baseball?). So financial planners are scrambling to meet their demands. Sound familiar?

Unusual Investments = Bad Results

While it's true that some sophisticated advisors have offered alternative investments to their high-net-worth clients for many years, when it comes to mass marketing, unusual investments usually end with unusually bad results. With due respect to Professor Santayana, the problem here isn't that financial planners are ignorant of the limited partnership debacle, it's that the profession, like the public, has drawn superficial conclusions from it, such as "Limited partnerships, bad; mutual funds, good."

In reality, a limited partnership is just a legal structure for a business, which on its own isn't any more good or bad than, say, corporations are after Tyco or WorldCom. Are you listening, Hollywood? A more reflective analysis of what happened during the 1980s might include the following lessons, which to my mind are more than relevant to today's advisors as they try to keep their clients happy and at the same time, keep them out of trouble:

Lack of Regulation. The recent mutual fund scandal notwithstanding, compared to the SEC's and NASD's regulation of the fund industry, limited partnerships looked like Deadwood. Aside from the securities sales requirements of disclosure and suitability (and quarterly audits and filings for public partnerships), LP general partners basically could do whatever they wanted. And many did. A friend of mine who was an independent partnership analyst in the '80s used to talk about one LP sponsor who sent his kids to college on the limited partners' ticket.

Among other things, the rates of return on unregulated investments are far from standardized. Many investments were complicated, with multiple pay-ins from the limited partners on the front end, a stream of payouts on the back, plus an overlay of various tax benefits. Analyzing the value of these returns was left up to the general partners, who often used internal rates of return or adjusted rates of return, neither of which was understood by the average financial planner--consequently both were easily manipulated.

What's more, as many of these investments held illiquid assets such as real estate or oil and gas wells, determining the value of a partnership's assets before final liquidation was subjective at best. Coming from the oil business when I began to write about these investments in the early 1980s, I couldn't understand why planners and their clients were so bushy-tailed about 15% to 20% partnership returns when much of that was coming from the sale of depleting oil and gas reserves. It wasn't return on investment, it was return of investment. However, not one planner out of 100 understood that.

Consequently, more than a few partnership sponsors literally manufactured very enticing returns in the early years of an investment so as to keep investors clamoring for their next partnership. Some firms even went so far as to sell properties from one LP to another at inflated prices, in a sort of modified Ponzi scheme that made their partnerships appear very successful, but eventually left the investors holding a nearly empty bag.

Ridiculous Loads. We can debate all day over what constitutes fair fees for managing client assets. Total costs range today between 1% and 3%, but compared to the heyday of limited partnerships, it's all chump change. I saw limited partnerships where less than half the client's money went "in the ground," meaning less than $0.50 on every dollar that a client invested actually went toward buying the assets: the real estate, gas wells, storage units, and so forth. That meant the general partner would have to run the partnership so well, he could make a competitive return with only 50% of the investment working. There were front-end loads, due diligence fees, sales fees, acquisition fees, GP expenses--the list went on and on. The bottom line was that most general partners, B/Ds, and the folks who sold the partnerships had already made a fortune long before the investors made a dime. Or didn't. By comparison, how well do mutual funds perform when they hold half their assets in cash? Are there some geniuses that could make this work? Sure, but how many Warren Buffetts do you think there are? More important, how many are willing to invest assets for your clients?

Lack of Professional/Institutional Investors. How rare is it that someone comes up with a truly new way to make money? One clear lesson from history is that it doesn't happen very often. Again, more important, how likely is it that such a genius is going to let your clients share in her discovery? Right. Not very.

There are long lines of sophisticated, wealthy individuals and institutions just waiting for such opportunities. Most of the small market of folks looking for investment capital prefer to work with them, because the costs of reaching them are low--as opposed to reaching your clients, where they have to pay a broker/dealer, a due diligence fee, mass marketing costs, and your fee. Consequently, the best or even just good alternative deals never make it to your clients. Moreover, the investments that do become available are rarely at the same terms that sophisticated investors get.

That's why the chances that your clients' alternative investments are going to work out are usually pretty darn low. In fact, often when LPs are buying, sophisticated investors are selling to them--getting out at what they think are ridiculously high prices. What's wrong with this picture? So if you're going to get in the alternative investment game, look to see what the big boys are doing, and try not to be the patsy. Remember, if you're sitting at a poker table and you don't know who the patsy is....

Case in point: I just read that some folks are offering investments in single-family homes. Sound good? Well, have you ever heard of an institution or a Forbes 400 listee who made their fortune buying up single-family homes? No? Hmmm. Perhaps that's because THERE'S NO MONEY IN IT. Lending money to homeowners? Sure. Banks built a whole industry on that. Renting homes to folks? Low margins, high maintenance: Fuhgeddaboudit. Better to buy a mortgage REIT.

One-time Investments. The biggest difference between investing in alternative limited partnerships versus publicly traded stocks or bonds--directly or through a mutual fund--is the incentive of the investees. The prime directive for CEOs of public companies is to keep their share prices up. It gives them power and clout and keeps their boards of directors happy. This is especially true of companies that have been around a long time--the agendas of IPOs are somewhat different. And guess what? They are more risky. Contrast that with limited partnerships that are essentially one-time investments. With most of their compensation up front, general partners often have no real stake in whether the investors make any money or not. So it shouldn't come as much of shock to find out that often they don't.

Perhaps the most important takeaway from the limited partnership years is that client-driven investments rarely end well. Sure, your clients want high returns like they used to get (on paper, at least). Of course, they don't want to invest in the stock market while stock prices are down to reasonable levels, from which point they're more likely to go up than down. That's just what clients do: The wrong things at the wrong time. The good news is, that's why they need you--to save them from themselves and the financial services industry that preys on their self-destructive instincts. In the '80s, far too many financial planners bent to their clients' wishes and their own short-term economics. Then they spent the next 10 years trying to rebuild their practices. The lesson is simple: Don't put your clients into investments you're not confident in. If they won't listen to you, you don't want them. Trust me. That's one lesson that history has shown time and again.

Bob Clark, a former editor-in-chief of this magazine, sagely surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at rclark7000@aol.com.
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