By Cora Pettipas
Our lives are built on assumptions. Our investment portfolios are as well. But what if the assumptions are not serving investors anymore? To go against mainstream assumptions is not easy, and feels akin to swimming upstream in a stiff current when mass media and business legislation is biased against new ideas and innovation. The exempt market is an industry that challenges the assumptions of ‘modern’ portfolio theory and how one can best build their wealth.
Contrary to popular belief, the blow ups and losses of the public markets far outstrip the losses in the exempt market. It is funny how people will often say, ‘you should not invest more than 40% of your portfolio in the exempt market.’ It is true that investing has risks, but it would be just as easy to say, ‘you should not invest more the 40% in the public markets.’ This article is not trying to demonstrate that one product structure (private versus public) is better than another, it is just trying to demonstrate that broad generalizations are dangerous, or ‘decivious,’ meaning deceptive information that is obviously inaccurate if thought about critically - the media can try to convince us that the sky is pink, but we can take the time to look up and see for ourselves that it is still blue.
Private Investments are Inferior to Main Stream Investments
The first assumption is that the exempt market has unhappy investors. Misrepresentation in the media is dangerous, as is holding on to antiquated beliefs propagated by them. It has been said if someone hears something four times they will believe it, and if they hear something six times they will repeat it as fact, a psychological concept called memory distortion. In fact, this was recently published in the esteemed publication the Investment Executive, “OBSI has seen a rise in complaints involving securities in resources sector firms and received a handful of complaints, most of which involved suitability, from clients of portfolio managers and exempt-market dealers (EMDs), which are now also required to use the dispute-resolution service.” To clarify this confusing message, the exempt market has had a very low complaint ratio in the past eighteen months under OBSI, much lower than expected at only four complaints in total. The raise in complaints is under the other registrant categories.
A second example is the article that appeared recently in the well-regarded MoneySense publication called “Be Wary of Private Investments” which cautions “When Ontario became the first province to loosen restrictions for investing in private capital markets earlier this year, it opened the floodgates to millions who may not have qualified previously.” This is untrue, as they were actually the last province to gain a retail market, not the first. It goes on to say, “Few investors will hear about private capital market investments from their advisors, who may not be licensed or approved to offer them. But that’s probably a good thing, since many investors would be ill-suited for these products.” It is interesting that the article so definitively, yet vaguely, states that the exempt market is ill-suited for investors, but cannot first accurately describe the basic information about the space. The investor trend is towards holding some private product. It has been noted in the U.S. market, which tends to trend about ten years ahead of Canada, that retail investors have increased their alternative portfolio holdings to 10%, which includes exempt-type products. It is also interesting to note this article had two big bank banner advertisements prominently displayed on it. It makes one question whether the mainstream media would be biased towards private investments, if the exempt space had large sums of marketing dollars for media, and the banks did not.
Fixed Income is Safe
GICs are safe. We hear this all the time. At the time of writing this, a five year GIC with my major bank was only 1.6%. This amount excludes any inflation and taxation. One rationalization in this low interest rate environment is that ‘it protects your principle.’ Inflation on prices, or more accurately: deflation of our currency, erodes these gains. In fact, if you believe the Consumer Price Index’s numbers, our flawed proxy for inflation, of 1.6 % inflation over the past ten years, all your gains are gone.
Most Financial Planners use 3% as an inflation adjustment to better reflect housing, energy and food cost increases that CPI does not accurately capture. If inflation is assumed to be three percent (and I think most people who track their expenses, especially their food bills, will agree it is much more than that) then the investor has an erosion of capital while their money is illiquid for five years. Also, if not in a tax preferred structure like a TFSA or RRSP, they are also losing up to half the 1.6% yield in taxes. You are actually paying for the erosion of your money while the banks can use it for free and lend multiples of it out to their clients to make money. I am not saying that this is a bad business model, just bad for the investor.
Other fixed income products, which have served investors so well in other decades, also fail to meet inflation. High quality government and corporate bonds currently pay around 2%, which does not keep up with real inflation, so the real value of a client’s principle is eroded in the long term. To attain higher yields, clients must invest in lower quality, or junk bonds where companies do not have adequate cash flows to cover these interest payments, so diversification is crucial.
Most likely, the real reason for the rising popularity of private investments is our low interest rate environment: as it leaves investors hungry for yield they used to be able to get from ‘safe’ investments that now erode their portfolio. The other issue with fixed income (or bonds) is that in a low interest rate environment like this, interest rates will normalize by increasing in the long term. When monetary policy forces interest rates up and pushes bond rates up, existing bond holdings will go down in value, further negatively effecting your overall portfolio. At this current time, bonds are riskier than they have been in the past, especially considering their lackluster returns at this time.
Public Markets are Great at Providing Growth
The next assumption is clients should be invested in the public markets to create portfolio growth. If a retail investor invested in a low fee, high quality, major ETF following the TSX S&P composite index, then a client would have a total of $14,512 after investing a lump sum of $10,000 ten years ago. The annual return on this is almost 3.8%. Again, this amount excludes any inflation and taxation. Your reward for being invested in (large cap) Canadian public stocks over that past decade is just under 1%, inflation adjusted.
You may say to yourself: ‘yes, but we had a major financial crisis in that time period.’ That is correct, but it is also correct that we have one about every ten years, the previous ones being the tech bubble crisis (2000) and the savings and loans crisis (1987). In addition, the correction happened early in the ten year time frame (the numbers would look much worse otherwise), and these ten years have been an epoch of historically low interest rates, which theoretically boost corporate profits and stock prices. More interesting is the risk, on March 2, 2009, your hypothetical investment of $10,000 would have been worth $6,994.00 on your account statement, showing a drop of 30% in two years. As an investor, you have to ask yourself if you feel adequately rewarded with a 3.8% before tax and inflation annual return, with an investment that has the potential at any time to drop 30%? The interesting thing is that this ETF is classified as mid risk (also referred to as moderate or balanced).
If you are an investor with a moderate risk tolerance (as most people are) and choose to go with a balanced mutual fund, which basically mimics a 60/40 equity/fixed income long position, the performance was worse than the ETF option above. A quality big bank balanced fund would have yielded 2.8% over the last ten years, before taxes and inflation. The approximate downside risk of this is again 30%. The illustrations given here are not going to be ‘apples to apples’ for all client situations, but are simply intended to demonstrate that investors should question whether they are currently being compensated properly for the level of risk they have to take on in the public markets. Investment goals, cash flows, risk tolerances, timelines and tax rates all need to be considered.
Liquidity is Good
Liquidity is good. Liquidity has two aspects: that you can convert your assets to cash relatively quickly, and that the investment value will be preserved in the process. True liquidity has both aspects. Public markets are touted as having liquidity, but that is not always true. Liquidity exists for public markets for larger cap companies with high trading volume and slim bid ask spreads, in ‘normal’ market conditions. A thinly traded stock, or a financial crisis, negates a public stock’s liquidity, so public markets were never intended as a tool for liquidity. Exempt market products innately have much less liquidity as there currently are no advanced secondary markets. Some issuers put liquidity provisions in their products, but as the funds are spent on productive purposes, they are limited in redemptions to their own sinking fund constraints.
Interestingly, in our zeitgeist of increased debt and low savings rates, liquidity should not be valued in long term savings, or building of a client’s nest egg. The government policy of pension funds intuitively reflects this, as there are ‘locking in’ provisions on pension funds. The only two ways to unlock (get access) to your pension money immediately are if there is a nominal amount ($25,000 or less) in the fund, or there is a case of financial hardship. I know someone who only has one exempt market investment left in their RRSP, because that was the only investment they could not cash out early, as all the rest went to immediate consumption ‘needs’ like a new car. I also know clients who are only retiring because they had a forced saving defined benefit plan (a scarce luxury these days), because they would have spent the money on a bigger house and more toys. Forced savings works.
I am not saying liquidity is not needed for clients, quite the opposite. Every person’s finances ideally should have an emergency or opportunity fund where they can draw from when needed (that is not a line of credit). In addition, a portion of the RRSP should be liquid to income spread, or withdraw from in lower or non-income earning years to decrease tax bills.
Private Investments are High Risk
Exempt products are high risk. Exempt market products produce higher returns, around 6-12%, sometimes homeruns make 20% plus per annum. However, they can sometimes fail, so diversification is important. A more realistic classification of private investments would be from mid risk to high risk, but they are classified as ‘high risk’ no matter the fundamentals of the underlying investment.
This is because of the structural set up, as they are not offered to clients with a prospectus, they are offered through a term sheet or offering memorandum. I regret to take a short diversion into securities law, but it will be quick. It is important to note that a prospectus and offering memorandum have the same information, and a legal requirement to be accurate. However a prospectus is vetted by regulators for accuracy of the information contained in the prospectus. What is not vetted or assured by regulators is the soundness of the business plan of the Issuer (investment) or the returns (or lack thereof) after the prospectus is offered.
The exempt market portion of a portfolio is painted with the ‘high risk’ brush by default, so it is difficult to accurately build an asset allocation. Exempt market investments are ‘private’ and are not ‘marked to market,’ as there are no past statistics on how they do as a group, unlike public markets. In addition, there is no uniform rating system for debt, like there is for public company bond offerings. However, it is intellectually lazy to classify a Mortgage Investment Corporation (MIC) containing first mortgages in urban centers with skilled management as the same risk category as a leveraged condo development offering in a low demand area with inexperienced management. They do not have the same risk or the same potential return.
To sum up, this article is not trying to demonstrate that one product structure (private versus public) is better than another, it is just trying to demonstrate that broad generalizations are dangerous. Circumstances change and what worked as wealth building investment strategies in the past may not work in the future, and it is ignorant to think that they should. And even though it is a regulatory requirement, generalizing one whole class of product structures as ‘high risk’ will lead to inaccurately categorized products. As we accommodate to the new financial environment, the financial pioneers and innovators in industry will hopefully come up with more effective asset allocations for investors and more accurate risk classification systems for these portfolios, to better serve clients in these constantly changing times. Until this happens these misleading assumptions will continue to be propagated.
Cora Pettipas CFP, FCSI, M.Sc., FMA, CIM, DBA (Candidate) is currently the Vice President and a Board of Director of the National Exempt Market Association (NEMA) in Canada. Cora is also the editor of Exempt Edge Magazine, the Canadian industry trade publication on the exempt market/private equity. She is also currently representing Canada on the editorial team of Financial Planet as well as the Education Working Group for international education initiatives for the Financial Planners Standards Board and a policy ambassador for the Financial Planners Standards Council. She holds a Bachelor’s degree from McGill University, a Master’s Degree (Finance) from Swiss Management Center University and is currently a Doctoral candidate in Finance there as well. Cora has had tenures with several financial institutions in the capacity of financial advisor, wealth management, investor services, retail banking, and financial planning. Her most recent previous position was as a Professor at Mount Royal University, where she taught Finance and Financial Planning. She has published and presented her work internationally. Cora is also the founder and Co-Owner of Melodic Twilight, a successful business venture which is internet based and sells in over 20 countries.
 Refer to a study called Inferring the Popularity of an Opinion from its Familiarity https://www.apa.org/pubs/journals/releases/psp-925821.pdf
 Keith Black, CAIA presentation in Calgary March 16, 2016
 Bank of Canada CPI estimate
 This article uses two packaged products invested in one lump sum ten years ago to simplify the illustration. In addition, the ‘safest’ public market samples were selected, meaning domestic large cap investments in inexpensive retail products. Utilizing emerging market or small cap examples would have resulted in more risk, but is beyond the scope of this article.