We include private investments in our portfolios because the returns are potentially higher. We think they are higher because investors demand more return to invest in a market where information is not readily available and where liquidity is challenging. We know from the evidence that institutional investors as a group are also increasing the percentage of their overall portfolios allocated to private equity. Extra return comes at a price and the price in private equity markets is access to information and networks of trusted contacts.

Many of the people we talk to have had experience investing in a “friends and family” round of a private company. While this investment is a private transaction, it doesn’t compare to our approach in this market. We expect that as a whole, the returns to private equity are higher so we want broad diversification. We win by accessing a broad exposure to this asset class. In our pooled approach we own 2-3% positions in any one private company on average. We think throwing all your money at one position represents too much risk of total loss of capital. In addition, there is excess reward available by using relatively better information to guide investment activity. Friends and family may be less focused on relative value than they ought to be. Private companies should pay a fair price for capital.

Publicly-listed securities represent a small percentage of all companies. There are 3 or 4 private companies for every public one. According to Tom Kennedy, Managing Director of Kensington Capital, there is profit available when markets are unbalanced:

“There are approximately 100 billion dollars chasing one trillion dollars in potential transactions in the private Canadian marketplace.  Excess demand for capital represents a great opportunity for potential investors.”

In Canada at least, there is much greater demand for capital than potential supply available. We like these odds, as market imbalances tend to favour one side; in this case the suppliers of capital as a group, who should expect to be rewarded with higher returns for risk assumed. It is important to understand that investors still have to do their homework and not all participants in private equity investments will be rewarded equally.

Public markets are often referred to as “efficient” in that most information about public companies is broadly understood. Information is readily available and instantaneously transmitted to a large audience. By comparison, information about private companies is generally not available. As a result, better information is a source of returns in the private markets.

The total return to public stock markets is the sum of all return to the participants in that market. Overconfident financial marketers are paid to encourage us to consider strategies to perform better than the probable outcome. By definition, not everyone can do better than average, and once fees are considered most will underperform the average of the group. We can’t all eat someone else’s lunch. If we want portfolios that perform better than average, then we should include assets like private equity that provide higher returns.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

The investment world doesn’t simply replicate the physical world. As illustrated in the table below, for year ending 2009, 57 percent of the world’s population account for 84 percent of total GDP and 95 percent of stock capitalization.

Simple strategies based on one factor, such as allocating large percentages of your investment dollars to China or India may randomly work out, but such strategies probably represent more risk than intended.

Risk without return is never a good thing. For example, China recently surpassed Japan in GDP but the Chinese stock market is less than a quarter the size of Japan’s. The size difference is a measure of relative risk, and a determination of required return from a new investor’s point of view. In this example, new investors in the Chinese market require more return for Chinese investments than for investments in Japan.

Capital is generally free to move between stock markets so the dollar value or market capitalization of each market is a summary of all investor views about the prospects for that market. In a sense, the wisdom of the many, each making independent decisions can be summarized by the willingness to invest in one market versus another. In this way, relative market capitalization represents risk adjusted return for country allocation. Bigger markets are less risky than smaller markets. They also probably provide less return. Risk and return are always related.

“Perfect Country Allocation” may be achieved by replicating the market capitalization below for each country: 42 percent US, 9 percent UK and Japan and so on. In diversifying by relative market capitalization, an investor would capture the return to stocks wherever that return is realised. This investment portfolio would increase with expanding markets and decrease with relative decliners. A portfolio would therefore be perfectly diversified as to country selection. If the goal is to capture growth wherever it manifests, then this portfolio would achieve the result. Diversification works best when it eliminates the risk that provides no aggregate return, leaving only risk that provides compensation. This portfolio would capture the return to increases in earnings. It would not capture the positive or negative returns resulting from capital movements between markets.

So why isn’t everyone doing this? I think the answer lies with spending. Investors and their advisors allocate more money to markets where the money will be spent. This is reasonable but somewhat inefficient in that the domestic market doesn’t capture price changes in imports. Great economies like Switzerland, Hong Kong and Finland have relative GDP of 10 times their population weight. Canada and the US have less than 5 times or half the measure. In time, goods from very productive economies get relatively expensive. Investing in these economies or companies compensates you for the price increases. You don’t want to be the greatest investor in an economy that is shrinking in comparison to the rest of the world.

Implication for Investors

International diversification increases complexity (risk) and expense for individual investors. Yet from a North American point of view many markets are growing faster than our domestic markets. A broadly diversified approach which limits the error of investing in the wrong country at the wrong time should allow your portfolio to experience better results. Big bets on individual countries add risks that you simply don’t get paid for in the long run.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

While most of the worries and economic turmoil persists, there has been some measure of relief to the stock markets. We are at a point of growing divergence between wall street and main street. More evidence is expected of shrinking economies in North America and overseas yet these backward looking measures were not reflected in the recent buoyant return to stocks across the world.

The short term return to investment returns is random but momentum trends do make themselves known. For this positive return environment to continue investors will have to ignore the results from main street. They will have to ignore the fact that consumers are saving more and deferring large purchases. The market will have to rally in the face of lower earnings reports from companies and yes more bankruptcies and higher unemployment figures. There are no assurances, risk is pervasive even from these price levels. If this is the beginning of a turnaround in fortune for the stock markets then it would be consistent with the beginning of other bull markets, shrugging off the bad news and climbing higher in spite of the evidence.

In the investment industry, risk is usually defined as volatility or differences in return experience when compared to the average expected value. If monthly returns are plotted, we would expect most values would cluster around the middle -  average value of  about one percent with progressively fewer values as we move away from the average.  This normal distribution would imply that values outside plus or minus 10%  should occur a couple of time every 100 years.   The stock market is different. There are many more large numbers – both positive and negative. Behavior finance experts explain some of this experience in term of investor psychology. In statistical terms this is a fat tail distribution. More values  appear at the extremes and the average value is less descriptive of actual experience. In 1987 the Dow dropped 23% in one day. That shouldn’t happen in our lifetimes, but it did.

Individual stocks are much more volatile than broad markets. The returns are similar, you just capture more risk to get similar returns and there is a big cost to getting it wrong. Yet risk to these approaches is often defined in terms of average volatility to broad market indexes. This is very misleading and causes a good deal of unnecessary confusion when portfolios don’t perform as advertised. It seems to me that an important part of our job as investment advisors is to minimize risk. We don’t try to manage money for improbable events, even if it would have worked last year. We mange assets so as to capture expected return with the highest probability of success. Fat tails shouldn’t alter that effort.

Rules For TFSA

Contributions are not tax deductible. You must be 18 years of age or older, a Canadian resident and be able to supply a valid social insurance number to participate. Initial contribution limits are $5,000.00 per year and will be indexed to inflation. Excess contributions will be taxed at 1% per month so this is something you really want to avoid. Unused contributions will be carried forward indefinitely. Contributions are not related to earned income. Any amounts withdrawn are added to the contribution room the following year.

Income and capital gain are not taxable while retained in a TFSA or when withdrawn. Income earned or amounts withdrawn will not be added to income tested benefits or credits delivered through the tax system. In addition these amounts will not effect OAS, GIS or Employment insurance benefits.

The qualified investments mirror RRSPs. Arms length entities such as stocks, bonds, mutual funds etc… . Small private shares may qualify subject to certain conditions. Interest on borrowed money to fund TFSA is not deductible., though a TSFA can be used as collateral for a loan.

No attribution rules apply so the TFSA will be used for income splitting purposes. The tax free status is lost at death though a tax free roll-over is possible if a spouse or common law partner is named as beneficiary.

Strategies

These flexible plans do not replace RSPs. They will be used most effectively in conjunction with pension type investments.  If you contribute a maximum to an RRSP and have savings outside that plan then the TFSA should be maximized.

Perhaps the best uses will be around family income splitting strategies. Parents or Grandparents can transfer up to $5,000. per year for each young adult or grandchild. Recipients can take the money out without tax and new room will be created for future savings.

This is also a welcome new vehicle for those who have high pension adjustments and have little use for RRSPs.

Other Notes

For young adults, a  tax return is required to build TFSA contribution room

Anti Avoidance rules apply to guard against transactions designed to shift taxable income to TSFA

This introduction will be supplemented by additional strategies in future posts.