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.
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 safeguard, 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 publicly 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.
