There are stocks that are listed and trade on the main exchanges and then, there are Pink Sheets stocks or Penny stocks. These are speculative stocks that should legitimately represent a share of ownership in a company that is not yet list on public exchange. Pink sheets are traded on an over-the-counter (OTC) market that connects broker-dealers electronically. There is no trading floor, the quotations are done electronically and the pink sheet-listed companies do not have the same criteria to fulfill as the companies listed on main stock exchanges.  Pink sheet-listed companies are usually not sound enough to be listed on a major exchange and in many cases, end up being victims of pump and dump scams. Furthermore, they tend to be thinly traded i.e. the daily volume of trading is very small and as such, are commonly found in portfolios of very high risk institutional or retail investors, not the average investor saving for retirement.

Another equally dubious product is the non-tradeable investments. Usually in the form of REITs (Real estate investment trusts), these non-tradable REITs are generally illiquid (i.e cannot be traded), often for periods of eight years or more. Early redemption of shares is often very limited, and fees associated with the sale of these products can be high and erode total return. But, these REITs promise high distributions for the illiquidity. However, the periodic distributions that help make these products so appealing can, in some cases, be heavily subsidized by borrowed funds. This is in contrast to the dividends investors receive from large corporations that trade on national exchanges, which are typically derived solely from earnings.

Given this knowledge, one would think there is no place for these investments in an average investors’ portfolio. But, you would be wrong.

Future Wealth’s View

The number of advisors who place these pink sheet stocks and non-tradeable REITs surrepticiously in clients’ retirement portfolios is surprisingly high. Why would they do that knowing fully well the high risk and illiquid nature of these esoteric instruments when there are over 5000 highly liquid companies, mutual funds and ETFs listed on NYSE or Nasdaq to choose from?

The answer lies in the commissions. Since these instruments are hard to trade, the commission received by the advisor could be ~12% or higher versus just pennies on a tradeable security. For example, if an investor puts $400,000 into a non-tradable REIT, only $352,000 is available to be invested into real estate because a commission of $48,000 was paid to a salesperson or advisor. This means the client needs a 12% return just to break even and cannot sell it easily when he or she wants to. On the other hand, the advisor could buy Google or Amazon stock for the full $400,000, less $6.95 in transaction fee, of clients’ money and allow the client to sell the entire position at a push of a button anytime he or she wants. But then, what is the fun in that for  the salesperson or the advisor? None.

This ugly practice was going to end last year with the implementation of the fiduciary rule (link to our article on fiduciary rule is here until the Trump Administration killed it and now, all the greedy advisors are back at it. There is something inherently insidious in taking money from clients and putting it in instruments that neither benefits them nor is it appropriate for their long term financial plan. But, in these times of alternative facts where the truth isn’t the truth, what was once considered abnormal behavior has become just another daily reality in America.