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Investing

Decivious: Questioning mainstream investment assumptions (Part 2)

April 11th, 2016 by

Busting myths about private investments, once and for all

 
 
 

Our lives are built on assumptions. Our investment portfolios are as well. The first part of this look at the top assumptions that negatively affect our net worth can be read here. In Part 1, we cover private vs. main stream investments and the 'safety' of fixed income investments. Now, let's investigate what we're often told about the markets, liquidity and the risk of private investments. 

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 percent, 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 percent 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 percent? 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 percent over the last ten years, before taxes and inflation. The approximate downside risk of this is again 30 percent. 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.[1] Investment goals, cash flows, risk tolerances, timelines and tax rates all need to be considered.

[1] 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.

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 percent, sometimes homeruns make 20 percent 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.

 

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