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Decivious: Questioning mainstream investment assumptions (Part 1)

April 4th, 2016 by

Why the exempt market is misunderstood


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 percent 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 percent 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.[1] 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 percent, which includes exempt-type products.[2] 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 percent. 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 percent inflation[3] over the past ten years, all your gains are gone.

Most Financial Planners use 3 percent 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 percent 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 percent, 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. 

We're just getting started...

In Part 2, we cover three more market assumptions that could be preventing you from reaching your true investment potential and give you some must-know exempt market tips. Keep reading for more myth-busting information!



[1] Referring to a study called Inferring the Popularity of an Opinion from its Familiarity https://www.apa.org/pubs/journals/releases/psp-925821.pdf

[2] Keith Black, CAIA presentation in Calgary March 16, 2016

[3] Bank of Canada CPI estimate


Jul 28 2017 2:00am

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