Degrees Of Separation
By: Marcin Drozdz
The word derivative has been well used over the last couple of years. A quick web search reveals countless articles and documentaries on how modern derivatives have plagued our financial system with everything from toxic mortgage backed securities to the insurance policies that accompanied them.
Webster’s dictionary defines a derivative as “a contract or security that derives its value from that of an underlying asset,” Wikipedia goes further to define a derivative as something that “has no intrinsic value in itself” and lesser cited sources have given even more colorful definitions.
Arguably then, one can say that the original mass produced financial instruments that derived value from an underlying asset were stocks and bonds. Fast forward through the paper based, over the counter platforms to the 20th century to a time when capital began to flow freely and tech friendly stock markets to trade these derivatives of debt and company equity began to emerge. As technology found new ways to supercharge business, the financial world too found new, more progressive ways to sell themselves. Financial products became packaged and marketed in various ways; from mutual funds to funds of funds. Today these products are bought and sold globally at a dizzying pace in everything from dollars, yen, and pounds sterling. Entire organizations exist to service and speculate on these modern tools of finance and convenience.
At present, Canadians hold over 773 billion dollars in mutual funds (source - IFIC), over 49 billion in ETFs (Canadian ETF Association) and countless billions in other publicly traded financial instruments. Institutional investors and pension plans alike have also traditionally been very heavily invested in public securities.
But as Bob Dylan once said, “The times they are a changing.”
Pension funds, sovereign wealth funds and everyday investors are all voting with their wallets and billions of dollars are flowing out of the public markets, searching for refuge and stronger risk adjusted returns investing directly in underlying assets. Topping the list of reasons why investment capital all over the world is reducing its exposure to public markets include: market complexity, sensitivity and costs.
Investors and advisors alike are finding it increasingly difficult to assess where the actual investment capital is being utilized in many retail investment products. Stocks, bonds, mutual funds, segregated funds, ETF’s, forex investment funds, hedge funds, funds of funds etc etc. There are more publically traded/listed/held product types available today than ever before and the vast majority of investors and advisors alike are ill equipped at determining what underlying assets are actually being acquired and how they create a return and mitigate risk. According to Investopedia mutual funds typically hold 100-150 stocks in each fund. Going one step further, many of those funds invest in other pools of funds, making it exponentially more difficult to review and even determine what the core assets that create value are. In 2004 Michael Norbrega CEO of OMERS pension plan and the man ultimately responsible for over 400,000 individual employee pension plans decided to shift nearly 50% of assets out of the public markets and invest them into select private offerings. His primary motive was to reduce their exposure to the volatility of the public markets and create more consistent income. With over 11 Billion raised in private offerings (Exempt Market) in Alberta alone in 2012, groups like OMERS are not alone in their search for less degrees of separation between them and their investment holdings.
Integrated communication technology has changed the game. Most retail investment products available today are reactive as much to systematic market risk (as was witnessed in the 2008 market crash) as they are to speculative news. For those social network experts out there you will recall the April hacking of The Associated Press twitter account where Obama was apparently injured during a bombing of the White House. The markets did not take this news lightly as it instantly triggered a burst of selloffs and in a matter of minutes temporarily wiped out over 136.5 Billion of wealth on S&P500 as people fled to cash for safety (Source: Daily Mail).
The costs of taking a company public and maintaining it have skyrocketed, eroding returns by passing these costs onto investors. The title of the September 2012 PriceWaterhouseCoopers article gets right to the point “Considering an IPO? The cost of going and being public may surprise you.” The 32 page document also includes quotes such as “87% of CFOs indicated that their firms spent more than $1 million on one-time costs associated with their IPO” and “On average, companies incur $1.5 million of recurring costs as a result of being public.” Going public has become an increasingly more expensive proposition and with the steady declines in IPOs since 2007 the evidence is becoming clear that vast numbers of investors of all participation levels are looking for less layers of fees and more direct access to investment opportunities. The vast majority of these opportunities are private investments in direct, underlying assets.
Wayne Dyer was once quoted saying “If you change the way you look at things, the things you look at change.” Depending on where you are in the investment capital markets you would be wise to consider a change in perspective also. For investors and advisors, it means setting yourself up for success by being aware of the trends in the capital markets as the landscape is shifting faster than ever before. Do not get left behind; with billions of dollars flowing into private offerings it’s time to become informed. There are courses you can sign up for, people you can interview and most recently a website was launched with some of the brightest minds in the space ExemptEducation.ca. If you happen to be an entrepreneur, you do not need to go public to raise millions to expand your business. Save money and invest some time. Engage a firm that specializes in offering memorandum and market consulting services to learn if taking your enterprise private is the way to go.
This article offers readers a different perspective on our financial landscape and hopefully helps make more sense of things. We currently live in a (financial) world where most investable products derive their value not from the direct output of a business but rather a packaged financial instrument that to varying degrees takes the actual business and value generation out of direct sight. The smart money is already in the know and cutting through the layers, removing degrees of separation and investing much more directly. It is time for financial professionals to take a look at private investment options