What is an Accredited Investor ? (Morningstar)

New Law Changes Wealth Definition


by Tim Galbraith | 07-23-10


President Obama just signed into law a sweeping set of financial reforms contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act. One significant change is the modification of the definition of an "accredited investor."

Accredited investors are a minority in the United States, as the description imposes high-net-worth thresholds. There are many details in the definition, but broadly speaking, the historical accredited investor standard meant investors had to earn $200,000 during the previous two years with the likelihood of earning the same during the forthcoming year. Alternatively, investors not meeting this income test could qualify for accredited investor status by having at least $1 million of net worth, which included all investments and, critically, one's home.

Accredited Growth
These income and asset rules were put into place in 1982. In that year, the SEC estimated that only 1.87% of U.S. households would pass either of those financial tests. With the march of time, inflation and asset appreciation increased incomes, home prices, and the value of other investments. Take for example incomes: Government statistics show that in 1982 the top 5% of households earned just more than $60,000 and by 2008 the income level was $180,000--an increase of 200%. Average home prices rose 237% in the same period, and in some metropolitan areas the appreciation was much more.

The SEC estimated that the percentage of accredited investors increased by 350% from 1982 to approximately 8.47% of households in 2003. In 2010 the percentage was likely higher despite the recent housing and 2008 equity market correction. Like many things that do not adjust for inflation, the old definitions got easier to meet and more investors, even though they may not have felt rich, were now members of the top investment club.

An individual who meets the definition of an accredited investor has access to a group of investment products unavailable to the retail masses, namely private partnerships that can invest in private equity, real estate, commodities, and hedge fund strategies. It is common sense that legislation put in place net-worth tests to limit access to these types of strategies, which typically have poor transparency, intermittent pricing, and episodic liquidity. However, more sophisticated investors who understand the greater risks could potentially benefit from greater return from these investments.

But as net worth increased over time, many investors found themselves technically eligible to be accredited investors, though their own investment proficiency was less than a perfect match for these complicated products. It is easy to imagine a pensioner or school teacher, not able to meet the $200,000 income threshold, but who owns a home in an affluent area, where the housing bubble lifted their net worth more than $1 million. Are they really an accredited investor, able to judge complex trading strategies, partnership tax treatment, or esoteric securities such as a collateralized debt obligation?

Wealth Redefined
The new legislation immediately removes the value of a home when calculating the $1 million net worth limit. Newly minted accredited investors must have true investments in excess of $1 million. The $200,000 income threshold remains unchanged. Additionally, after four years the SEC has the ability to increase the $1 million bar to account for inflation, eliminating the problem of having a fixed net worth hurdle that gets easier to jump with the passage of time. Existing investors who no longer meet the newer accredited standards may not be forced to redeem, but no new money will be permitted to be added unless the investor qualifies.

The most immediate impact of this legislation will be felt on those operating investment products that are limited to accredited investors, namely private partnerships, including hedge funds. The tighter standards will shrink the number of prospects, forcing these partnerships to target larger qualified and institutional clients. Additionally, there will be more scrutiny on partnerships to ensure their accredited investors really meet the new standards. Ultimately, an investment partnership is responsible for ensuring compliance with all securities laws, particularly Regulation D of Rule 501 in the Securities Act of 1933, commonly known as "Reg D." This is where the definition of accredited investor is detailed and the rules of private fund investor solicitation are laid out.

"No one conducts financial audits or demands absolute proof of net worth," says Rory Cohen, partner at the law firm Venable LLP. "But clients typically attest to their net worth through subscription documents, on which broker-dealers and funds rely. Ultimately, the investment partnership is responsible for its ability to assert compliance with the Reg D safe harbor. Partnerships ought to show some reasonable level of diligence in confirming that an investor meets the eligibility requirements."

For funds that target accredited investors, the responsibility to meet the new standards falls to the fund and its general partner. Adds Cohen, "Funds should have a pre-existing substantive relationship with each investor, through which they could gain sufficient information about an investor's occupation and financial circumstances to better assess whether they are accredited. When in doubt, it would be prudent to ask for a tax return."

What are the penalties for failing to meet the Reg D requirements? "Failure to adhere to the private placement requirements could lead to fines and potentially far more punitive measures," says Cohen. The ultimate sanction would be closing a fund and liquidation. The high fees charged to investors by hedge funds means many funds are wealth-creation machines for their fund managers. For a fund manager charging a 2% management fee and a 20% performance fee, closing a partnership is the equivalent of taking the Golden Goose to a barbeque.

For retail investors, it can be argued that the new higher standards to become an accredited investor provide additional protection. Investors can be better matched to investment products that suit their level of understanding and sophistication. For clients and financial advisors, once again, suitability reigns supreme.

One other possible outcome from the new definition could be an increase in the number of mutual funds and exchange-traded funds that attempt to mimic the same strategies as these private partnerships. If you run a private partnership, the new definition means there are fewer prospects; asset raising is more difficult and more costly.

One option is to scrap your partnership and open a mutual fund, where there is no net-worth threshold for investors. The numbers of these alternative mutual funds are growing, and include such hedge fund styles as long-short and market-neutral. Morningstar's last count was 153 funds, with more in the pipeline. For retail investors, the benefits include daily liquidity and pricing, a 1099 tax form instead of a K-1, and no minimum net-worth requirements.

We are encouraged by these changes as they provide additional investor protections. Time will tell if this legislation will be the catalyst for new financial product innovation, nudging private money managers to open mass-appeal products. We are hopeful and very watchful as innovation brings new but not always enduring products. The lasting lesson is something we've known all along, that client suitability is timeless, and knowing your client (and their limits) is a protection that legislation can never universally provide.

Data Sources:
Census.gov (housing data) http://www.census.gov/const/uspricemon.pdf
Census.gov (top 5% income) CPS data
U.S. Congress conference report for HR4173
Federal Register / Vol. 72, No. 2 / Thursday, January 4, 2007 / Proposed Rules (SEC) stats on numbers of accredited investors

Tim Galbraith is head of alternative investment strategies for Morningstar Associates, LLC.

Highest Yield (from Kiplinger Magazine)

Where to Find Top Yields
From safe municipal bonds to risky closed-end bond funds, just about everything is on sale.

By Jeffrey R. Kosnett

From Kiplinger's Personal Finance magazine, June 2009

It's been an excruciating year for income hogs, their favorite investments obliterated by the recession and the credit crunch. Since September, high-yielding standbys such as real estate investment trusts, master limited partnerships, business-development companies, and oil-and-gas royalty trusts have lost 50% or more. Junk bonds and emerging-markets debt have improved of late, but they've still sustained double-digit losses.
From calamity, however, springs opportunity. Many income securities are now tantalizingly cheap. Moreover, issuers of high-yielding stocks and bonds are sure to benefit from reflation -- the stimulation of global economies through massive government spending and rock-bottom interest rates. Reflation, which implies higher inflation, will hurt low-yielding Treasury bonds, but it should boost the profits of energy producers, real estate operators and highly leveraged companies that need to raise prices to prosper.


The bear market in most income investments has resulted in lower cash payouts, too. With virtually all segments of the real estate sector suffering, dozens of REITs have cut their distributions, and many are paying dividends mainly in stock. Energy trusts have trimmed their disbursements because of low prices for oil, natural gas and other products. Led by financials, hundreds of companies have cut or suspended dividends on their common stock this year.

Credit-market chaos wreaked havoc with the recommendations in our previous "yieldfest" (see Earn 8% or More, July 2008). Our best picks, emerging-markets bond funds such as Fidelity New Markets Income and Pimco Emerging Markets Bond, dropped about 10% over the past year through April 9. Pipeline stocks, such as Kinder Morgan Energy, also held up reasonably well. But we had our share of disasters. For example, First Industrial Realty Trust cratered by nearly 90%, while Genco Shipping & Trading dived 73%.

As the economy begins to improve, the rest of this year and 2010 will be much more rewarding for income seekers. From the safest to the riskiest, we offer our best bets for big cash returns over the coming year (of course, you should keep money that you'll need soon in supersafe instruments, such as money-market funds and bank accounts).

Municipal bonds
The recession is putting pressure on state and local coffers, so why feel good about the prospects for municipal debt? Munis, which rarely default, are yielding far more than comparable Treasury securities. This state of affairs is an anomaly because interest from munis is generally free of federal income taxes. And because munis offer such generous yields, they should hold up far better than Treasuries when the economy and inflation pick up. Still, to be on the safe side, we recommend avoiding tax-free bonds with maturities greater than ten years. At ten years, you can still find 4% to 4.5%, tax-free. That's the equivalent of 6% or so from a taxable bond. Ten-year Treasuries, by contrast, yielded 2.9% in mid April.

Like most other sectors of the bond market, munis suffered last year, but confidence in them has improved. Despite California's budget disaster, the state sold $6.5 billion of general-obligation bonds in March, the third-largest muni issue ever. These A-rated bonds have already gained value. In mid April, a California GO maturing in 2019 with a coupon of 5.5% sold at $1,050 for each $1,000 of face value to yield 4.7% to maturity. For a Californian in the top income-tax bracket, that's like getting 8% from a taxable bond. And for the highest earners living elsewhere, it's the equivalent of 7.2% from a taxable bond.

Some discount brokers, such as Fidelity and Charles Schwab, offer scores of good-quality tax-exempt bonds supported by taxes or the revenues from water bills, highway tolls and the like. In mid April, a representative ten-year, double-A-rated, noncallable water-system bond, such as an Orlando utilities commission issue, yielded 4.8% to maturity. If you prefer a fund, Baird Intermediate Muni (symbol BMBSX) was the top medium-maturity muni fund in both 2007 and 2008. Other standouts include Fidelity Intermediate Municipal Income (FLTMX), a member of the Kiplinger 25, and Schwab Tax-Free (SWNTX).

Ironclad mortgages
Toxic mortgages are the match that lit the financial firestorm, but you can't blame government-guaranteed loans from the Veterans Administration or the Federal Housing Administration. The VA foreclosure rate is 1.7%, compared with 13.7% for adjustable-rate subprime loans.

The best way to own these loans is through a Ginnie Mae fund. Backed by the full faith and credit of the federal government, the Government National Mortgage Association guarantees packages of FHA and VA debt bundled together by private lending institutions. From the perspective of timely repayment of principal and interest, Ginnie Maes are just as safe as Treasuries but deliver significantly more yield. And although mortgage rates have fallen, many GNMA funds still own lots of older, higher-paying loans. For example, almost 40% of the loans in Vanguard GNMA (VFIIX) carry yields of more than 6%.

Vanguard's fund and other low-cost Ginnie Mae funds, such as Payden GNMA (PYGNX) and Fidelity Ginnie Mae (FGMNX), still yield about 5%. GNMA yields should decline by half a percentage point by the end of 2009 because lower mortgage rates encourage more borrowers to refinance. But these securities will generate higher cash flows after mortgage rates, like other long-term rates, start to turn up later this year.

Bank-loan funds
These funds hold slices of adjustable-rate loans and lines of credit that banks extend to companies with junk credit ratings of single-B or double-B. Adviser Mark Gleason, of Wescap Management Group, in Burbank, Cal., aptly calls a bank-loan fund "a hybrid between a junk-bond fund and a money-market fund." The bank funds currently yield 4.5% to 6%, which is far short of junk's double-digit yields. But their loans are safer because their terms are short, their interest rates float with changes in short-term rates, and they are ahead of bonds on the repayment pecking order should the borrower default. However, like stocks and junk bonds, bank loans gain value prior to or in the early stages of an economic recovery. Year-to-date through April 9, bank-loan funds returned an average of 11.1%, tops among bond-fund categories.

By contrast, in the three-month period that ended last November, the average bank-loan fund lost 29% as the credit crunch and selling by hedge funds slashed the value of bank debt. But defaults didn't get out of hand, so funds such as Fidelity Floating-Rate High Income (FFRHX) and the closed-end PIMCO Floating Rate Strategy (PFN) kept up decent monthly distributions even as their share prices dropped. These payouts are sliding because short-term interest rates are near zero, but bank-loan funds still offer better yields than short-term-bond funds. Gleason sees annual total returns of 9% to 11% through 2012.

Triple-B corporate bonds
This is the sweet spot in taxable bonds. In 2008, the gap between yields of a basket of triple-B-rated bonds and Treasuries exploded from two percentage points to six and a half. In mid April, the gap was almost five points, which is attractive when you consider that bonds rated triple-B are still considered investment-grade. Moreover, the category harbors a bunch of recession-hit companies that traditionally have carried single-A ratings. Today's triple-B roster includes Altria, Burlington Northern, Johnson Controls, Kraft Foods, Black & Decker, Sunoco and XTO Energy. All will thrive in better times.

For safety's sake, choose bonds from across several industries. Noncallable bonds are nice, but as rates rise, you won't see many redeemed early anyway. In mid April, an Altria bond maturing in 2018 and carrying a 9.7% interest coupon was priced to yield 8% to maturity. Bank and insurance bonds offer high yields because financial issuers are riskier than industrials, despite government efforts to keep them afloat without nationalizing them.

Pipelines
Energy prices will rise as industry expands and people drive more. So you can buy energy-income investments at sale prices and hold on for what should be higher future dividends. If you think oil prices will zoom or if you just want to hedge against inflation, buy BP Prudhoe Bay (BPT), a royalty trust that passes through cash from the sale of crude oil. BPT crashed last summer and has cut dividends two times since, but it's back to $68 from a low of $50, and it yields 6%.



If you don't want to gamble on energy prices, pipelines and storage facilities are the ticket. Their dividends depend on the amount, not the price, of the products that move through these systems. Energy Transfer Partners (ETP), Kinder Morgan Energy Partners (KMP) and Magellan Midstream Partners (MMP) all have long histories of delivering dividends reliably, and they currently yield from 8.8% to 9.2%. Because these firms are set up as master limited partnerships, they'll send you a Form K-1 at tax time, rather than a Form 1099, and that could mean extra work filling out your returns.

Preferred stocks
It wasn't just common stocks that went on a tear after bottoming on March 9. Preferred stocks, which act a lot more like bonds than stocks, also rallied strongly. From March 9 through April 9, iShares U.S. Preferred Stock Index (PFF), an exchange-traded fund, rocketed 66%, although it remains 45% below its 12-month high. Tom Taylor, of Thoma Capital Management, in Towson, Md., notes that a preferred stock from Bank of America (BAC.H) yields 14% to maturity in 2013 and cannot be called or exchanged. The stock surged from $5 to $15 between February 19 and April 9. But its face value is $25, so it can still go higher.

Preferreds, despite the reassuring name, are not risk-free. Issuers can cut or suspend preferred dividends, as a handful of REITs have done during the financial crisis. And if a company files for bankruptcy, bondholders take precedence over preferred investors. You can spread your risk with a fund that focuses on preferreds. John Hancock Preferred Income (HPI), a closed-end fund, owns far fewer financials than does the iShares ETF. At its April 9 close of $12, the fund traded at a 4% premium to its net asset value and yielded 15%. It would be better if the fund traded at a discount to NAV, but the modest premium is acceptable.

Junk corporate bonds
Let's face it: Recessions are not good for junk bonds and their issuers. Junk-rated companies are young, troubled, highly leveraged, or some combination of the three. So it's not surprising that they suffer when sales sink and questions about their ability to service their debt mount.

But the current recession has been less discriminating than most. Previous junk-bond routs involved "bad companies with bad balance sheets," says Mark Durbiano, a manager at Federated Investors who has seen the good, the bad and the ugly during a 25-year career investing in high-yield bonds. This time, he says, investors pummeled bonds of essentially good companies, such as First Data and SunGard, whose high debt loads earn them junk ratings. The average junk bond recently yielded 18%, a near-record 15 percentage points more than Treasury bonds.

But now, with signs that the economy is thawing and bargain hunters nibbling, things are starting to look up. The average junk-bond fund, which lost 26% last year, returned 6% in 2009 through April 9. The indexes -- but not the whole sector -- will take a temporary hit if General Motors, a huge junk-bond issuer, defaults. But the three primary junk ETFs -- SPDR Barclays Capital (JNK), iShares iBoxx $ High Yield (HYG) and PowerShares High Yield (PHB) -- hold few or no GM bonds (but plenty of health and technology issues). Each yields 10% or higher.

Wild closed-ends
We've saved our lottery tickets for last. Scott Leonard, of Trovena, an advisory firm in Redondo Beach, Cal., seeks out income-oriented closed-end funds in struggling but improving sectors that are leveraged, selling at big discounts to NAV. Dozens qualify. Consider, for example, Cohen & Steers REIT and Utility Income (RTU). At its April 9 close of $5.28, the fund sold at a whopping 25% discount to NAV and yielded a similarly massive 26%. Or look at BlackRock California Municipal Income Trust II (BCL). At a price of $10.18, it traded at a 19% discount to NAV and yielded 6% tax-free. Don't put more than 5% of your income assets into these kinds of funds because when they're bad, they're really, really bad.



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Your Retirement Paycheck: Model Portfolios from Kiplingers Magazine

Investments That Pay You Every Month
These three portfolios should produce reliable yields of 5% to almost 10%.

By Jeffrey R. Kosnett

May 4, 2009

In the summer of 2008, I devised three portfolios composed entirely of investments that pay dividends or interest every month. These portfolios are ideal for people who need spending money, as opposed to those who invest in bonds, real estate investment trusts or other kinds of income-oriented vehicles for diversification. The yields on these portfolios ranged from 6% for a mix of moderate-risk bond funds and high-dividend stock funds to more than 10% for a riskier collection of energy royalty trusts, leveraged bank-loan funds and foreign-currency bond funds.



For the most part, the dividends have held up -- the notable exceptions being the oil-and-gas pass-through investments and the bank stocks. But the principal has fallen far more than I imagined even remotely possible. By the time the stock market bottomed in March, share prices for a package of energy income trusts, bank-loan funds and REITs were, on average, half of what they were in mid 2008. If you had started the aggressive, high-income portfolio in June or July of 2008, you were probably down 30% or so on a total-return basis.

Not surprisingly, the lowest-risk portfolio did considerably better, although it, too, was in the red. That package had one-fourth invested in energy and other high-wire stuff, one-fourth in a high-dividend, exchange-traded stock fund, and the rest in Vanguard Total Bond Market Index. The portfolio generated about 8% in income and lost about 20% of its market value -- lousy but, all things considered, tolerable.

Assembling a ladder of Treasury bonds over the past year would have produced a small capital gain, but it would have left you far short of needed income. And that's still true today. You can't build a high-income portfolio -- whether it pays monthly or less frequently -- without taking some risk with your principal.

The good news is that all of these high-risk categories are past the worst. Junk bonds and bank-loan funds have been recovering handsomely in 2009. Ditto for REITs. Payouts -- and share prices -- of oil-and-gas trusts remain depressed, but energy prices and cash disbursements will rise as the world economy improves.

Still, the fact that such formerly trouble-free investments as Enerplus Resources Fund (symbol ERF), a trust that owns a diversified package of energy-producing properties in North America, and Eaton Vance Senior Floating-Rate Trust (EFR), a closed-end bank-loan fund, could lose more than 50% in less than a year is troubling. Many reputable financial advisers and I believed that investments that paid a steady stream of income would be fairly stable. That perception is another casualty of the financial crisis.

So it's time for a new, post-collapse edition of the Cash In Hand Monthly Income Plan. You may have less principal now, but the principle remains the same. You choose from among three approaches: Shoot for maximum yield of 9% to 10%; go conservative and pick up about 5%; or take a middle-of-the-road course. The growing number of bond ETFs (see Welcome Additions: More Bond ETFs), which make monthly distributions, provides some fresh choices. Only a few open-end bond funds, REITs and energy pass-throughs pay 12 times a year (although virtually all Vanguard bond funds pay monthly).

High-risk, high-yield plan
Estimated yield: 9.5%

35%, energy trusts. Energy is still the leading category to hunt for high current income. The typical royalty trust or master limited partnership is priced to yield about 10%. Choose at least three out of a group that includes names such as Cross Timbers Royalty Trust (CRT), Enerplus, Penn West Energy Trust (PWE) and Provident Energy Trust (PVX). All are fairly diversified. Avoid trusts that sell only natural gas. Gas should be a good long-term investment, but there's a surplus of it now and its price will stay depressed longer than oil's price will.

20%, bank-loan funds. The best no-load, open-end fund in this category is Fidelity Floating Rate High Income Fund (FFRHX). Among leveraged, closed-end funds, two possible choices are BlackRock Floating Rate Income Strategies Fund (FRA) and BlackRock Floating Rate Income Strategies II (FRB). In early May, both sported high yields, and their share prices traded at discounts to the value of their underlying assets (that's a must if you invest in a leveraged closed-end). Two parts Fido to one part BlackRock sounds like a good recipe.

15%, corporate junk bonds. Vanguard's low-cost, no-load offering, Vanguard High-Yield Corporate (VWEHX), is the first choice here. Loomis Sayles Bond Fund (LSBRX) is really more of a go-anywhere fund, but it usually holds a substantial amount of its assets in junk bonds and emerging-markets bonds, as well as investment-grade corporates. The fund, a member of the Kiplinger 25, yields about 9.7% and complements the Vanguard fund well.

15%, real estate. The anchor of every check-a-month plan should be Realty Income (O). This is a high-quality, one-of-a-kind REIT that calls itself the Monthly Dividend Company. It owns more than 2,000 properties leased to well-known retailers and restaurant chains. Realty Income has paid 463 consecutive monthly dividends. Not every streak is solid these days, but this one is as close as you can get to a sure thing. Plus, the share price fell far less than that of most REITs during the market's downturn. Realty Income yielded 8% in early May.

10%, preferred stocks. The PowerShares Preferred Portfolio (PGX) is an unleveraged ETF that passes through dividends from an array of preferred bank and utility stocks. It has stabilized after losing half its value from May 2008 to February 2009.

5%, emerging-markets bonds. Two ETFs, iShares JPMorgan U.S. Dollar Emerging Markets Bond (EMB) and PowerShares Emerging Markets Sovereign Debt (PCY), invest in bonds from such places as Russia, Brazil, Turkey, Indonesia and Mexico. After running into trouble in the fall of 2008, the funds, both of which pay monthly, have rebounded handsomely.

The centrist plan
Estimated yield: 8%.

Choose among the same funds, trusts and ETFs as above, but tweak the allocation to make room for a chunk of investment-grade corporate bonds. You could split the high-grade bond exposure between Loomis Sayles Bond and an ETF such as iShares iBoxx Investment Grade Corporate Bond Fund (LQD). The mix:

20%, energy trusts.

20%, investment-grade corporate bonds.

15%, bank-loan funds.

15%, Realty Income.

15%, corporate junk bonds.

10%, emerging-markets bonds.

5%, Vanguard GNMA (VFIIX). The soundest mortgage-related investment around, this Vanguard fund invests in securities backed by the full faith and credit of the U.S. government.

The conservative plan
Estimated yield: 5.5%.

The conservative plan emphasizes the entire range of bonds, including Treasuries (which can't go bust but yield next to nothing and will almost surely lose value if inflation accelerates and if interest rates rise). Then we add some other safe, high-yield categories for balance.

60%, diversified, high-quality bonds. Pick either Vanguard Total Bond Market Index (VBMFX) or its ETF sibling, Vanguard Total Bond Market ETF (BND). You'll get paid about the same each month; the main disadvantage of the ETF is that you incur commissions every time you buy or sell.

10%, energy trusts.

10%, Realty Income.

10%, bank-loan funds.

10%, Vanguard GNMA.


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