Up, Down & Sideways: Statistics in the Exempt Market.
By: Christophe Voegeli, BSc, CP, CFFA
With the school season back upon us, it can be a good time to revisit some lessons. Over the last year, I have had the privilege of writing two articles in the Exempt Edge with an academic focus. The first article focused on ways to measure the performance of an investment and the various rates of returns used in finance. The second article focused on risk, its various sorts, and the impact risk can have on a client’s portfolio. In this article, I seek to expand on the calculations of risk, with a focus on valuation, volatility, and correlation.
Statistics Class and the Exempt Market
Volatility of return is often referred to as standard deviation, or the directly related sister, variation. These are some of the main risk measures with investments as they capture the swings in returns over time. Sometimes investors prefer a steady 6% per annum versus wild swings from year to year to average only 7% per annum (over the same holding period). Risk to capital aside, lower volatility is one of the main attractions of the exempt space. In fact, many performance measures ranking investments on a risk/reward basis will credit these investments for reducing volatility. All things equal, less volatility is better.
Other terms like covariance and correlation also enter the risk picture. Both covariance and correlation express the relation of one investment to another (or to a broad index, like the stock market). When one investment goes up - Does the other investment go up, down, sideways, and by how much? This is the idea of correlation (and covariance to a closely related degree). Again, certain performance measures will capture correlation, attributing more value to investments with low correlation to a certain suitable benchmark, versus high correlation.
Tolerance of return variation is made of up of factors like investor’s needs, preferences, time horizon, psyche, and whether or not they have other assets which could absorb losses elsewhere. For example, a younger client with no intent to touch investment assets for a few decades can absorb the risks of volatility.
While it can be tempting to begin speaking about volatility and correlation in the exempt space, it is key to know that they are as much about statistics as they are about the asset class or investment performance. Again, using the words volatility and correlation is inextricably linked to the data surrounding the investment, as well as the quality of the data. Valuation data of the investment is what drives these measures, and the less frequently there is valuation data, and the lesser the quality of the valuation data, the less statistics should be mentioned at all.
Dealing Representatives (DRs) should understand the difference between an asset with a static price (like a land project) and an asset with low volatility; they are not the same thing. An asset with a static price simply has no high frequency method with which it can be valued. An asset with low volatility can be valued, but has low swings in its asset price and total return.
Why is Valuation Such a Big Deal?
While the psyche of investors and their knowledge of what their investments are worth should not be undermined (for better or for worse), the focus here is on an investment’s valuation and how it relates to correlation and volatility. For assets with no secondary markets (like the Exempt Market, in nearly all cases), the valuation data is on a best efforts basis, often based on estimates, appraisals,
and internal management projections.
Good examples of exempt products that usually try to offer valuations are yield products (including MICs, REITs, and flow-through shares). By appraising real estate, checking the value of resource stocks on the TSX-Venture exchange, or by doing some estimating of the creditors borrowing from the MIC, these instruments usually carry decent valuation mechanisms.
This said, be cautious. The more the appraising is based on guess work (especially if it is all done internally), the more the risk of a sudden investment write down (or write up). Audited financials can help, but these are far from a perfect safe guard, as often accountants depend on management’s insights for valuations. These ‘valuation shocks’ are without a doubt one of the greater risks of the exempt space. Despite someone’s best attempts, when guess work is at play and estimates must be made, there is a chance of an appraisal bias. The greater the chances of this bias, the greater the valuation risk.
A fund that provides liquidity and valuation on a best efforts basis, but holds any amount of illiquid assets, can suffer from an appraisal bias. Its performance measures will reflect lower volatility, making it appear more attractive, but lacking perfect valuation creates somewhat of a false metric. Insurance companies, private equity funds, certain hedge funds, and exempt market space assets can all exude this tendency. It’s not that anyone is necessarily lying; rather, it is important for the DR to think about the quality of the data which can make up a marketing brochure.
In many cases however, valuation data in the exempt space is nonexistent or lagging. A great example is a land or real estate development; how can one try to peg a number to its value? Efforts are possible, but an issuer rarely makes that effort as it is both expensive and difficult. This is why land investments usually appear at book value until the day they exit. That is, you rarely truly know what the investment is worth until it exits or it is sold.
The Bottom Line
The key point is that in contrast to publicly traded securities (with their daily valuation mechanisms in place), valuation data of the exempt space is typically an estimate or nonexistent. It is critical for a DR to understand that lacking data for what an investment is worth over its holding period does not warrant them stating it is low volatility, nor low correlation to a certain benchmark. Rather, the investment simply has so little data that no statistical tool can be employed to capture any measure of volatility or correlation.
The merit of using an exempt asset, and its potential for low or lagging correlation to the broad stock or bond market, when compared to that of a mutual fund, for example, may hold to a degree, but that does not mean they are lower volatility, nor lower risk. It simply means there is less data for such statistical commentaries to be made. This distinction is important for DRs and the investing public to understand.
Public vs Private
When drawing comparisons of the public markets to the exempt space with respect to volatility, it is more accurate to say that an exempt asset may respond to different factors (and indeed the same factors) than the public markets.
For example, the stock or bond market could respond with great immediacy if central banks made major announcements, while a MIC’s yield would likely suffer no impact.
However, if the broad economy suffered to the point where the MIC’s assets were impaired (much like stocks and bonds could be), the MIC would eventually suffer a valuation change, or a drop in yield. At what time the MIC expresses the write down could be based on many business and valuation factors, potentially blanketing, or deferring, the true value being recognized (up or down).
This concept, much as it relates to an appraisal bias, is called valuation risk. Broadly speaking, the pricing mechanism of the exempt product is almost guaranteed to be far inferior to the pricing capacity of the public security. The retail client must be told this, as they are often only familiar with investments from the public world.
Correlation is also dependent on statistics, technically speaking. Poor statistics (ie: valuation data) means correlation statements should be used with caution. When commenting on correlation, much like volatility, it may be better to simply say that two investments may respond differently to various economic factors. Price movements could be related, but it could be for very different reasons. The bottom line is the less robust the pricing mechanism, the less the words correlation or volatility should be used.
A Unique Exception
One of the unique exceptions in the exempt space is flow-through investments, as they usually hold publically traded stocks. In fact, any structure holding highly liquid securities will be a rare exception to the guidelines discussed in this article. While the pricing of the flow through may happen only every few months, there is at least some valuation; in such a case statistics can be drawn up. Interestingly however (and DR’s should always think actively to what is behind the structure), flow through stocks are often on junior markets.
Pricing in such markets could be strong, but it could also be somewhat challenged, as the stocks are often thinly traded. While more detail on this is beyond the scope of this article, the concept here is that just because something is on a public market, does not mean it is priced perfectly. For example, a mere few million dollars of sale activity for a junior stock can drive its price down in a hurry. While valuation risk may be lower with flow throughs (as they can be well valued generally speaking), the investment risk likely remains moderate to high due to their resource and exploratory nature.
For hedge funds, if the instruments they hold can be valued well, they can also express strong, high quality data for valuation and statistical commentaries. The challenge with hedge funds however, is that their positions to certain assets may expose them to wild swings in value very quickly. Unlike the broad swings which a large bank stock may exude (which are often semi predictable), a hedge fund can have a much more dramatic movement, ironically linked to the exact same bank stock, due to the use of leverage and/or derivatives.
Does the Client Understand the Language?
When contrasting the public space with the exempt space, instead of saying the investment is low volatility, it is more accurate, and better for the client, to comment on how the assets are priced. DR’s should understand that exempt assets’ pricing mechanisms, where applicable, are such that swings in the underlying assets’ prices will not be reflected in the exempt asset’s price with the same immediacy the client may come to expect with a publically traded investment, if at all.
To help clients understand, ask them what their house is worth. The DR may explain that best case, they hire a professional appraiser and even still the appraiser could be wrong. Thereafter, it could be noted that if the housing market booms or busts, the appraiser’s estimates may change, but until the client sells her home, she does not know the value of it with complete confidence.
Her house may have boomed with economic growth or inflation, much like the stock portfolio she monitors weekly, but how she comes to be made aware of both these price changes is rather different.
To extend this example, if the home is a large unique farm out of the city, the valuation guess work from the appraiser will be less accurate than if the home is a cookie cutter townhouse in the middle of a large city. This example can help contrast the valuation abilities of one investment to another, even within the exempt space. Client communication is paramount, and examples a client can relate to only help a DR’s duty to serve.
Guessing at Losing?
While discussing loss of principal, with valuation data in mind, can one predict the probability of a loss of principal? With exempt assets, much like stocks and other investments, there is a chance some or all of the principal could be lost. Whatever that probability, it must be recognized and this theme reinforces the value of sound diversification, in and out of the exempt space, and proper planning.
In the exempt space, attempting to estimate the probability of a principal loss is at best a guess, and it is effectively impossible to attach a probability to the event. In the case of publically traded assets, the probability of loss is still a guess, but there are statistics behind the asset, as there is valuation data. While any analysis looking at past data will suffer from what is called hindsight bias, a lot of strong data can help someone’s guess work. The more public, the more liquid: the more data. This data can help make estimates. In fact, a common risk measure in the stock and bond markets is VAR (value at risk).
The calculations aside, the net outcome of a VAR statement for an investor with a million dollars reads something like this: there is a 5% probability that you could lose at least $50,000 in one month, and we are 99% confident of this. Indeed, this statement is littered with statistical theory, and again, much like the above paragraphs, valuation data is paramount: no data means no statistical comments.
In the exempt space, no such statement can be formed, but clients should be aware that they could lose money; the loss could be severe or mild. DR’s should always ensure clients understand their principal is at risk in the exempt space. The draw to investing is investment upside, potential tax benefits, and seeking performance behaviours perhaps not tied to public data in the same way public markets are.
It is Better to be Vaguely Right than Exactly Wrong
With no shortage of investment professionals who have used or paraphrased the above quote (originally coined by Carveth Read, not Keynes, nor Buffett), it is a great way to think about valuation. If a best efforts, realistic, and appropriately used valuation mechanism is employed, then this can be great for the investor, DR, and issuer. Behavioural biases of the investor ignored (sometimes it can be good to not know how a long term investment is performing) valuation can be a positive investment attribute. A DR’s job is to communicate appropriately the many features of the investment, valuation and risk included.