In Over Your Head

Shirley M. Mueller, M.D.

Though it goes without saying that people shouldn't invest in entities they don't understand, it happens all the time. When it does, the investor is often sadly the loser. Right now, one investment firm is taking advantage of those less knowledgeable investors.

It is prudent when using our hard-earned money to try to make a profit in the stock market to be aware of our human capacity to think we know more than we do. Though it goes without saying that people shouldn’t invest in entities they don’t understand, it happens all the time. When it does, the investor is often sadly the loser.

There is one recent example profiled by Jason Zweig in the July 14 issue of The Wall Street Journal that is too good to miss. For those who didn’t read that column, I will expand on it here while emphasizing how it affects investors.

Cornerstone Advisors of Asheville, N.C. has a laughing gas of sorts for their investors. It is high dividends, about 21% of net asset value. If this sounds too good to be true that’s because it is. The catch is that the return to investors is not gleaned from the profits Cornerstone made with the money entrusted to them, but from investors’ original monies or from newly invested cash from other investors.

This is the story. Cornerstone Advisors runs three closed end funds, all of which return the high dividends mentioned above. The company actually describes this on Morningstar in its policy statement more or less the same for Cornerstone Total Return Fund (CRF) Cornerstone Strategic Value (CLM) and Cornerstone Progressive Return Fund (CFP):

“…a fixed, monthly distribution to shareholders being maintained. The current rate has been set at an annual rate of 21% of the net asset value. To the extent that these distributions exceed the current earnings of the Fund, the balance will be generated from sales of portfolio securities held by the Fund, which will either be short-term or long-term capital gains or a tax-free return-of-capital”

The funds have to do this because they have so little generated from their investments. Return on equity (ROE) and return on assets (ROA) give an indication of a how a company is creating earnings from its investments, which, in turn, can be repaid to investors.

An acceptable ROE is 15% and ROA is 5%. For CRF and CLM, ROE is less than 1.5% and ROA is less than 0.5%: both are unacceptable. Normally, ROE and ROA are under the Key Statistics column on Yahoo! Finance, which is where I found them for CRF and CLM. They are not given for CFP.

There are other problems with Cornerstone, too. As a closed end fund, it is less transparent than publicly traded mutual funds or exchange-traded funds. That can make it hard to detect strategies of the fund that are not advantageous to investors.

For example, Cornerstone Advisors double dips. It charges a management fee and the funds it invests in do as well. An unsophisticated investor would likely not appreciate these double fees that are subtracted from any gain the fund might glean.

What is even more remarkable in this scenario is that it is not just individual investors who place money with Cornerstone who theoretically might not know better. Institutions do, too. For example, Raymond James & Associates own 1.9% of CRF. Rockwood Partners LP owns 2.37%. It would seem to me that this is not a good way for them to protect the money of their investors.

Think of it this way. There is a rotten tooth at Cornerstone (a lack of return on the money the advisors invest). This tooth needs to be extracted. One way is for the fund to close and return money to clients. Evidently they don’t do this because their management fee is too attractive to them to put their investors ahead of it.

Another would be for the shareholders to get smart and withdraw money. Then, at least the investor protects herself or himself. But, instead, they are mesmerized by the high-dividend return, the laughing gas that keeps them in a perpetual state of happiness about what they apparently think is happening (that the fund is performing well), but isn’t.

There is a saying derived from Sun Tzu in The Art of War: “Know your enemy.”

Here the adversary seems to be the fund itself. This is because it is only logical that if more money is returned to investors than Cornerstone Advisors is making, the fund will eventually go broke. Where would the trusting investors be then?

Read more:

High Rates? Are You Delirious?The Wall Street Journal

The Differences between ETFs and CEFs

Closed-end Funds Offer Risk and Reward

NOT FOR NOVICES