Education

Inflation and the economic recovery will support portfolio managers looking for deals

By: Dwarka Lakhan

After a decade-plus period of outperformance by growth stocks, value stocks are poised to benefit from improving economic conditions.

Late last year, value stocks began outperforming growth stocks as vaccine approvals and the prospect of increased stimulus in a Democrat-led Washington led to a rotation based on optimism about a global economic recovery. Over the past year, the Russell 1000 Value index has outperformed the Russell 1000 Growth index.

Several drivers are set to continue supporting a value cycle, including healthy consumer and corporate balance sheets and a resilient banking system. Fiscal spending will also play a big part in this cycle and should support economic and wage growth.

Value investing also will benefit from rising inflation and the potential for higher interest rates.

“Moderately rising inflation is constructive for value strategies,” said Richard Wong, senior vice-president, portfolio manager and head of the Mackenzie Cundill team with Toronto-based Mackenzie Investments. “If rising inflation is due to good economic growth and leading to higher interest rates, it’s very good for value strategies and quite negative for growth strategies.”

Wong, portfolio manager of the $1-billion Mackenzie Cundill Value Fund, said he anticipates the value rotation will accelerate if inflation stays above 2%.

Furthermore, “earnings over the next year could trigger the shift away from growth stocks because we believe the pandemic pulled forward a lot of revenue and profit growth for technology companies into 2020 and early 2021,” he said. “The current multiples on growth stocks don’t account for this potential future weakness.”

As of July 31, the Mackenzie fund had a one-year return of 22.6%, while the Morningstar Global Markets GR CAD index was up by 25.3% over the same period.

The Mackenzie fund uses a bottom-up strategy to invest in global equities and usually holds about 60 securities. The fund invests in three types of value stocks: deep value stocks, which are significantly out of favour and very cheap; cyclical value stocks, which lead their respective sectors but are cheaply valued and near the trough of their industry cycles; and quality value stocks, which have recurring revenue and can compound their earnings over time.

“During the initial and middle phases of an economic cycle — where we think we are now — we would have more exposure to deep value and cyclical value,” Wong said. “As the economic cycle slows and the risk of a recession emerges, we would move more exposure to quality value stocks, which are more resilient.”

The Mackenzie fund is currently overweighted in cyclical sectors such as financials, consumer discretionary, energy and materials. “We see many businesses yet to fully capture the improved economic and demand environment in their valuations,” Wong said.

Meanwhile, the Mackenzie fund is underweighted in consumer staples and health care. “These sectors could face less upside in a strong economy,” Wong said. The fund also is underweighted in technology “as it’s more difficult to find out-of-favour and low-valuation stocks in that sector,” he said.

One of the fund’s largest holdings is Montreal-based SNC Lavalin Group Inc., a fully integrated professional services and project-management company. “Under the leadership of a new management team, SNC is transitioning to a pure-play engineering services firm, where it will have better visibility and less volatile earnings — which should re-rate the stock meaningfully higher,” Wong said. “We believe that on a sum-of-the-parts basis, SNC is significantly undervalued relative to peers.”

Another major holding is General Motors Co., the multinational auto manufacturer and distributor. Wong said GM is one of the few manufacturers that can make EVs “that consumers want to buy and at scale, given the significant [research and development] investments required to succeed.”

Within the past six months, Wong also bought shares in California-based Skechers USA Inc., the world’s third-largest footwear brand. “The brand is positioned to deliver quality and style at mass price points,” he said, and is “investing heavily in direct-to-consumer and e-commerce.”

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In recent years, “the valuation discrepancy between growth and value stocks became so large that people started to take notice,” said Don Simpson, vice-president and portfolio manager with Dynamic Funds, a division of Toronto-based 1832 Asset Management LP. “The bigger the discrepancy, the better for value stocks.”

Simpson, who manages the $1.3-billion Dynamic Value Fund of Canada, said conditions favoured a rebound in value stocks once the economy began to improve and interest rates began rising. Like Wong, Simpson believes “a little bit of inflation” is good for value stocks in sectors that benefit from higher prices, such as commodities, consumer staples and financial services.

As of July 31, the Dynamic fund had a one-year return of 28.7%, while the Morningstar Canada GR Canada index was up by 29.0% over the same period.

The Dynamic fund invests in a diversified mix of businesses that have the ability to grow and generate good cash flows. The companies should have strong balance sheets and management teams that “we know and trust,” Simpson said. The portfolio is diversified by industry and ideas, and comprises 30 to 40 names.

Simpson said he determines which businesses are undervalued by meeting with management teams in order “to find out what makes the businesses tick.”

Simpson uses a bottom-up investment strategy to select stocks, but pays attention to how his ideas will play out in macro conditions. “What will happen if something goes wrong?” he asks himself.

The Dynamic fund’s heaviest weighting is in financials, with one-third of that in alternative asset managers such as Power Corp. of Canada and Onex Corp. Such companies are extremely undervalued in the current environment, Simpson said.

Power Corp., a major holding in the Dynamic fund, is trading at a 30% discount to its net asset value. Simpson said the firm has taken steps “to collapse its complicated holding structure,” and that its subsidiaries continue to experience strong growth under good management. Onex Corp., meanwhile, is trading at a 25%–30% discount, he said.

Within the past six months, Simpson bought shares in Fairfax Financial Holdings Ltd., a company with interests in insurance and investment management. Simpson said the company has a solid balance sheet, good execution capabilities and the potential for healthy growth. Further, its insurance business will benefit from higher prices.

Simpson also bought shares in Winnipeg-based Winpak Ltd., a leading manufacturer of plastic packaging for the food industry. The company is a “Steady Eddy business with a reliable stream of free cash flow,” he said. Winpak also has a large amount of net cash on its balance sheet and “a lot of room to grow.”

The energy sector comprises 9% of the Dynamic fund’s holdings and the fund “has been rotating back into pipelines, which have good free cash flows,” Simpson said. “The valuation discount is so wide that you are getting paid for the risk.”

As of July 30, the fund has a 5% weighting in communication services, 8.5% in industrials and 6% in health care.

Within the past six months, Simpson sold the fund’s holding in Minn.-based Ecolab Inc., a water purification company, because “its multiple got too stretched.” He also sold Apple Inc. because of its high valuation. Apple is a quality company, Simpson said, but he “found better ideas” in Canada.

© 2021 Investment Executive. All rights reserved.

Help your clients avoid these common misconceptions and missteps that can put their retirement at risk

By: Dwarka Lakhan

Although retirement expectations vary widely, most clients look forward to what they perceive as a comfortable retirement.

For some, planning for retirement is all about having sufficient money to last them through their golden years. For others, retirement is about maintaining an emotionally and physically healthy lifestyle, which involves both financial planning and lifestyle planning.

Regardless of your clients’ expectations, the path to a comfortable retirement is fraught with risks, challenges, myths, mistakes and misconceptions. If you don’t help your clients address these potential stumbling blocks early on, their retirement dreams could be badly compromised.

Your role as a financial advisor is to help your clients understand the potential risks they face, dispel the myths and beliefs they may hold, and help them avoid making mistakes that can derail their plans, in both the accumulation and deaccumulation phases of retirement planning.

– MYTH: RETIREMENT BEGINS AT 65

“Retirement has become a more fluid concept and clients should be more flexible in choosing to retire at a certain age,” says Matthew Williams, senior vice president, institutional and client services, with Franklin Templeton Investments Corp. in Toronto.

For older generations, age 65 was the “magic number” for retirement. But with people living longer, a phased retirement – during which clients may engage in part-time work, work at a reduced pace or pursue a “dream job” such as consulting after age 65 – may be the answer. Although these choices may not be ideal for your clients, making them aware of alternative retirement options is important.

“In the old days, people retired at 65 and probably lived for only another 10 years or so,” says, Francis D’Andrade, vice president, private client services, with Forstrong Global Asset Management Inc. in Toronto. “[Now], you probably have one-third of your life left after age 65.”

In fact, the average Canadian male lives for 22.6 years beyond the traditional retirement age of 65; the average Canadian female lives for another 24.5 years.

Increasing longevity is one of the primary financial risks clients face in retirement. They run the risk of outliving their money or having to adjust their planned retirement lifestyle to accommodate a reduced income, which may have to be stretched over a longer period.

– MYTH: THE GOVERNMENT WILL PROVIDE

Clients must be aware that they could face unplanned expenses, such as increasing health-care costs and the need for long-term or assisted care as they get older, Williams says. There are likely to be other large expenses, such as home repairs, which could also place undue stress on clients’ retirement funds.

Clients often mistakenly believe that various levels of government will cover all their health-care and associated expenses.

Heather Holjevac, senior wealth advisor with TriDelta Financial Partners Inc. in Oakville, Ont., says long-term care in a reasonably comfortable facility can cost as much as $60,000 a year, which can be a huge drain on a retirement portfolio.

Some clients anticipate lower expenses during retirement and, in some cases, they may be correct. Some of the costs associated with working – such as clothing, transportation and meals – will drop. But in many cases, Williams says, clients will spend more in retirement as expenses for travel, recreational activities and home renovations may rise. Either way, clients must understand the importance of budgeting.

When determining how much money is enough for retirement, there is no “magic number,” says Prem Malik, investment advisor with Queensbury Securities Inc. in Toronto. Each individual is different and a client’s desired retirement lifestyle will determine his or her financial needs.

– MYTH: “IF I BEGIN LATE, I CAN CATCH UP”

The way clients invest for retirement is key to ensuring that they have sufficient funds to last them a lifetime.

“On their own, most clients don’t have a process in place,” D’Andrade says.

For example, some clients believe they can begin saving late, then play catch-up to save sufficient funds for retirement. Some set their sights on accumulating a certain dollar amount – say, $1 million. Still others have expectations of unrealistically high returns from their investments.

Make sure your younger clients understand that beginning early in investing for retirement is crucial. Your clients’ investments will benefit more from the power of compounding returns the earlier they start to invest.

– MISTAKE: INVESTING TOO CONSERVATIVELY

One of the biggest mistakes some clients make is to invest more conservatively as they draw closer to retirement. They fear losing the money they have accumulated and, consequently, reduce the risk in their portfolios by reducing their exposure to equities and investing in fixed-income products instead.

You need to make clients aware of the hazards of investing in low-risk, low-return fixed-income assets, Holjevac suggests. When you take into account inflation and taxes in this low interest rate environment, clients who invest in low-yielding investments could end up with a negative real rate of return. This strategy poses a bigger risk than investing in equities because a client could run out of money sooner by investing too conservatively.

Instead, your clients should have a balanced portfolio that includes exposure to equities for long-term growth – because some clients may spend more years drawing down on their retirement funds than they spend on accumulating those funds.

Although investing in some equities is advisable at all stages of retirement, remind your clients that no one can predict the behaviour of the financial markets and how it will affect their retirement portfolio.

A decline in the markets during the early years of retirement can lead to depletion of the assets available for later retirement years. For example, if a client loses 10% of the value of a portfolio worth $100,000 early in retirement, only $90,000 will be left to grow in the portfolio to support future retirement years.

Although clients can use a variety of strategies to reduce market risk, Malik suggests using a tiered investment approach: assets required to meet financial needs for the first five years are invested in short-term securities; those to be cashed out in the next five years are invested in equities and fixed-income; and those not needed for 10 or more years are invested in equities.

When making investment decisions, you must ensure that your clients’ portfolios are structured to generate sufficient income to meet their expenses at the various stages of retirement. This is an important risk that should be avoided, Williams says.

– MYTH: “MY INHERITANCE IS MY RETIREMENT PLAN”

A significant myth among pre-retirees is that the wealth transfer from parents and grandparents will secure their retirement, Malik says. Some clients are in for a rude awakening when they find that their parents plan to spend as much as they can while they’re alive.

In fact, the intergenerational transfer of wealth is loaded with uncertainties. Factors such as increasing longevity, rising health-care costs and taxes can deplete the value of portfolios your clients expect to inherit.

Williams sees the wealth transfer as a “real risk” in which the value will be heavily discounted. Some elderly clients, he says, are spending too much.

Holjevac adds that many people have debt and mortgages heading into retirement, which means that there will be less to leave to their children.

Conversely, elderly clients may be gifting too much to their children too soon, putting themselves at risk of having insufficient funds during retirement, she says.

– MISTAKE: IGNORING INSURANCE

Another mistake some clients make is paying insufficient attention to insurance, Williams says. The older clients get, the higher the probability of disability and critical illness and the need for long-term care, says Malik. Clients should understand that insurance can help offset the cost of these potential life events and prevent the need for dipping into retirement savings.

In addition, life insurance can offset the costs of probate fees, income taxes on deemed dispositions and other expenses related to estate planning – costs that can be a burden on a client’s family.

Many clients think of retirement saving as a “current expense for a future benefit, with no instant gratification,” D’Andrade says. That’s why they tend to have a short-term focus when planning for retirement. Thus, it’s your role to bring clients in line when developing their long-term retirement plans.

The key to successful retirement planning, Malik says, “is to develop a trusting relationship with [clients] so that they can discuss all issues with you and know that you will come back with unbiased, honest advice.”

© 2017 Investment Executive. All rights reserved.

Helping clients meet their financial goals rather than beating benchmarks

By: Dwarka Lakhan

Som Seif, unfazed by increasing competition in Canada’s ETF industry, is confident about building out Toronto-based Purpose Investments Inc., his second foray in the rapidly growing territory.

“I have always been good at having a vision for the future, and focusing on that has let me have my white space – or opportunity – to innovate while not having to worry about the competition that comes along with that innovation,” says Seif, Purpose’s CEO and an engineer by training.

Seif is focused on creating an investment company that delivers products that have a specific role (the “purpose” in Purpose Investments) in the construction of robust, resilient portfolios.

He does not believe in traditional benchmarks, such as broad market capitalization-weighted indices. He contends that a well-constructed portfolio is created by using investments that carry different risks and which must be resilient in different types of investment environments, both positive and negative, with sources of returns that are independent from overall equities or bond markets.

Seif previously was active in the ETF market as founder and president of Toronto-based Clay more Investments Inc., launched in 2005. That firm focused on non-market cap-weighted or fundamental indexing, which, at the time, was a disruptive strategy that married the principles of active money management with those of passive money management. Claymore grew to $8 billion in assets under management in seven years to become Canada’s second-largest ETF portfolio manager. The firm was sold to BlackRock Asset Management Canada Ltd. in 2012.

Seif’s approach with Purpose is different, for the most part, from his peers – who, he says, focus primarily on generating smart beta and use quantitative indexing. “That is what I was doing 12 years ago,” he says.

Instead of just attempting to generate beta – whether it is fundamental or active beta – Purpose focuses on achieving desired client “outcomes” or goals -that is, generating returns that are tied to a long-term goal instead of to a benchmark.

“We care a lot about whether or not we are beating the markets over the long term, but we never care about three-month, six-month or 12-month periods. We think about three-year and five-year periods,” Seif says. “Unfortunately, the investment industry, including ETF and mutual fund players, are focused on the idea of benchmarks.”

The ETF industry is “missing out on what clients really want [because] clients care about meeting their liabilities and goals; they don’t care about beating the S&P 500 [composite index],” he adds.

In the life of a well-thought-out ETF portfolio, he says, there will be periods in which short-term performance will be sacrificed to ensure that the portfolio does well over the long run. This is what makes Purpose’s philosophy different, says Seif: “We have no insecurities about underperforming at times when it is necessary to underperform.”

And Seif believes that clients, and financial advisors in particular, are becoming more aware of the necessity for long-term thinking in portfolio construction. They also recognize that although both active and passive money managers have a role in the construction of a long-term portfolio, the marriage of these two strategies is necessary to be successful.

As the ETF industry evolves, Seif believes, lower-fee money managers – and not passive index-based providers – will garner the greater share of AUM, and that alternative investments will comprise a larger part of clients’ portfolios: “These are the two most important underlying trends that our industry is facing today, and we have positioned ourselves right in the middle of them.”

Purpose offers a diversified suite of 22 ETFs – the core of the firm’s product line – as well as mutual and closed-end funds.

Using a disciplined, rules-based investment approach, the firm’s ETF strategies include long-weighted equities, long-short equities, volatility, tactical bond strategies, strategic hedging and alternative real assets. Given current low interest rates, Purpose does not offer a pure long-bond ETF strategy.

Purpose’s long/short equities-based strategy is designed to hedge market risks, with the goal of delivering an equities’ return, but with substantially less downside risk.

Seif notes that alternative investments “are beginning to attract a greater share of wallet because of the current low interest environment and the recognition that traditional portfolios are not going to be as rewarding as they have been in the past 20 to 30 years.”

In the alternative space, Purpose’s real asset strategy provides purchasing power and inflation protection, using equities and commodities from inflation-sensitive industries and sectors such as agriculture, precious metals and real estate.

© 2017 Investment Executive. All rights reserved.

Explain why some mutual funds, such as emerging markets, funds incur higher expenses than others

By: Dwarka Lakhan

As the second phase of the client relationship model (CRM2) comes into effect, you will no doubt be having a significant number of conversations with your clients about fees. One aspect of this topic that is often misunderstood by clients is mutual fund fees.

In spite of the trend toward lower mutual fund fees, the fees for some funds remain relatively high — because of the expenses incurred in attempting to generate higher returns. It is therefore important that you help your clients understand why certain funds may have higher fees than others.

“The fees for some funds are higher largely due to the investment strategy of the fund,” says Caroline Grimont, senior vice president, marketing and sales, with Excel Funds Management Inc. in Mississauga, Ont.

For example, she says, equity funds — particularly emerging market and global equity funds, which invest in various foreign markets — generally have higher fees because they incur more expenses to invest in these markets.

Grimont says that investors should not just look at the fees of a fund, but rather the value clients receive for the fees they pay. Clients should focus on the “net amount in their pocket,” she says. A fund with higher fees that consistently shows higher net earnings than a fund with lower fees is worth investing in.

> Components of the fee
Explain to your clients that the fee charged by a mutual fund is often referred to as the management expense ratio (MER), which comprises two parts. The first part is the cost of managing the fund. This management fee, which is disclosed in the fund’s prospectus, includes the cost of a portfolio manager to oversee the fund and make investment decisions.

The other component of the MER is the fund’s operating expenses, which are variable and include costs such as fund administration, accounting, legal fees, client reporting and the harmonized sales tax.

> Why Fees Differ
“The investment strategy of a fund is one of the main determinants of differences in the fees charged by mutual funds,” Grimont says.

Equity funds usually have higher fees than fixed-income funds because, in addition to the cost of a portfolio manager, these funds may also use analysts and risk-management professionals to assist in selecting stocks. The manager may also incur expenses to meet with the executives of various companies prior to making investment decisions.

However, explains Grimont, an equity fund that invests in stocks within a single market has lower expenses than one that invests in several global or emerging markets. For example, portfolio managers of an emerging market fund may hire sub-advisors in foreign markets and the lead manager may have to visit foreign companies in which the fund invests.

“Investors need to be aware that as they move further away from traditional markets, active management has been proven to be more effective in generating [performance], which comes at a cost,” Grimont says.

In addition, funds with a global focus may use currency hedging strategies to minimize currency risk when investing in various markets, thereby incurring additional expenses.

Rule changes create opportunities, but they may not be available or suitable

By: Dwarka Lakhan

The new offering memorandum (OM) prospectus exemption provides retail clients with the opportunity to invest in myriad private-market investments that previously were available only to high net-worth, institutional and pension investors.

However, availability does not necessarily mean accessibility and suitability, which can limit the options for your clients.

The exemption took effect on Jan. 13 in Ontario and is expected to become effective on April 30 in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan. (See story below for details of the changes.)

“The OM rule change brings more choice to retail investors,” says Radovan Danilovsky, equities analyst with Accilent Capital Management Inc. in Toronto. Specifically, they now have access to private investment products in a range of categories, such as real estate development, mortgages, energy, oil and gas, receivables factoring, short-term lending, royalty funds, venture capital, lease financing and agriculture.

OM investments also can offer unique, non-traditional investment opportunities. For example, an investment portfolio of fine wines offered through an OM is too small and specialized to be considered seriously by large institutions, but may appeal to individuals, Danilovsky says: “Without the OM exemption such opportunity would be exclusive only to a select group of wealthy individuals.”

Among the more popular products in the current low interest rate environment are higher-yielding investments, such as mortgage investment corporations and receivables factoring, which can meet your clients’ demand for higher yields, says Vipool Desai, president of Ara Compliance Support in Toronto.

Adds Brian Koscak, president and general counsel with Pinnacle Wealth Brokers Inc. in Calgary and vice chairman of the Private Capital Markets Association of Canada: “With interest rates at historic lows, bond yields have dropped significantly, leaving investors searching for investment options that can generate higher yields in their portfolios.”

Typically, OM-based products are non-correlated to traditional public-market investments, such as mutual funds, bonds and equities, and have the potential to provide higher returns, says Koscak. And by adding a non-correlated OM product to a client’s portfolios, you can enhance diversification and reduce risk for that client, says Danilovsky.

For example, he says, “Investors with a passion for micro-capitalization stocks in, say, mining exploration, technology or biotech, may opt to invest in a professionally managed OM-based small-cap or venture-capital fund, as opposed to investing in individual stocks through a brokerage account.”

However, OM investments can be much riskier and are less liquid, depending on the type of investment and the size and reputation of the issuer. Says Koscak: “There are different risk/reward profiles for private companies, and investors in the private market generally accept the higher degree of risk [in exchange] for potentially higher returns.”

But Danilovsky argues that not all OM-based investments are risky or speculative. For example, he says, “An investor may buy shares [offered by OM] of a closed-end hedge fund focusing on a basket of mature, blue-chip companies with a specialized mandate of income preservation and dividend-income maximization.”

This would indicate lower risk, he adds, albeit in a hedge fund structure.

Michael Banwell, certified financial planner and president and CEO of Banwell Financial Inc. in Toronto, looks at investor risk from a different perspective. He contends that by investing in non-publicly traded vs publicly traded securities, investors “are substituting market risk for the skills and the risk profile of the underlying manager of the OM product.” From a compliance standpoint, Banwell ranks all OM investments as high-risk.

Although OM investments offer new opportunities, they are not necessarily readily accessible to all retail clients because OM investments can only be distributed through broker-dealers and exempt-market dealers. “Not everyone can sell exempt-market securities, including mutual fund and life insurance advisors,” says Koscak.

In addition, many of the eligible distributors do not support OM investments. “Firms want to keep their lives simple and stick to traditional products on their shelves,” says Desai.

By doing this, distributors reduce their regulatory hurdle, he adds, because OM investments require a great deal more compliance scrutiny. As well, firms take into consideration whether these investments will compete with other products on their shelves.

Furthermore, some financial advisors are reluctant to be certified to invest OM investments, even if their firms support these investments. Although Banwell’s firm carries OM products, he says, “As advisors, we take a step back and think of the added work required to scrutinize OMs, the added risk they bring when they are supposed to lower risk in certain instances and decide that they are just not worth the effort.”

Banwell is particularly concerned about small issuers: “Quite frankly, venturing into the OM world with small issuers makes me nervous. From a portfolio-construction perspective, OM products make total sense. However, from a practical standpoint, many of these alternative strategies fail to work out as expected.”

Another potential problem is that the average retail advisor is not familiar with many OM products, says Desai.

Adds Banwell: “I would say most average advisors do not understand the space, strategies and different types of risk [of OM investments], and I believe many [advisors] are not interested in understanding or playing in this space.”

Koscak contends that education is key to understanding OM investments. His firm focuses on providing education for advisors on the products it distributes.

Further limiting accessibility to OM investments is that not all make it to the product shelves of distributors that choose to carry OMs. These investments are subject to comprehensive due diligence that involves reviewing the firm’s business, and its financial and non-financial information. This entails, among other things, reviewing the OM documents, financial statements and marketing materials, and examining the business operations of the issuer.

“Our role is that of gatekeeper or detective. We look for red and yellow flags as part of the due-diligence process,” says Koscak. The due-diligence report is presented to the firm’s product review committee, which either approves or rejects the OM.

“The due-diligence process is about knowing your product [KYP],” says Desai. “Some of the considerations that typically go into the process are how long the issuer has been in business, the assets it has under administration and its track record.”

The KYP process varies among dealers. However, KYP comes down to whether an investment is suitable for an investor. “The change to the OM exemption rule does not change the fundamental rule for dealing representatives to ensure they only make recommendations that are suitable for investors,” says Koscak. “[Advisors] should pay particular attention to documenting the case for suitability.”

In the April issue: The risks inherent in exempt-market investing.

The second of three articles in a series on exempt-market investing

HOW THE RULES HAVE CHANGED

Under Ontario’s new offering memorandum (OM) prospectus exemption, the total cost of OM-based securities that an eligible investor can acquire within a 12-month period cannot exceed $30,000.

However, eligible investors who have received advice from a portfolio manager, investment dealer or exempt-market dealer on the suitability of such investments can invest up to $100,000 a year.

An eligible investor is someone whose net income before taxes exceeds $75,000 – or $125,000 combined, in the case of an investor and spouse – in each of the two most recent calendar years and who reasonably expects to exceed that income threshold in the current calendar year; or an investor whose net assets exceed $400,000. (An ineligible investor – whose income and assets lie below those thresholds [a.k.a. an “average” retail investor] – can invest up to $10,000 a year.)

The existing rule that allows accredited investors (individuals who meet criteria for being designated an accredited investor, or a family member, friend or business associate) to invest in OM securities remains in effect.

© 2016 Investment Executive. All rights reserved.

Retail investors in Ontario now have access to securities that previously were available only to accredited investors

By: Dwarka Lakhan

The introduction of a new offering memorandum (OM) prospectus exemption in Ontario on Jan. 13 makes raising capital easier for businesses. At the same time, the OM exemption creates new investment possibilities for your clients.

“The introduction of the OM exemption is a big step forward for issuers in Ontario, which previously had to deal with a narrow population of accredited investors or family and friends,” says Peter Dunne, partner, securities registration and compliance practice, with law firm Cassels Brock & Blackwell LLP in Toronto.

Ontario is the last Canadian jurisdiction to adopt such legislation. The OM exemption opens a wide range of exempt-market investment opportunities that have not been available to retail investors before now. The attraction of these investments, which are largely private, are lack of correlation with equities and fixed-income securities, and the potential for higher risk-adjusted returns.

The OM exemption is “in line with the continuing effort by the Ontario Securities Commission (OSC) to facilitate a cost-effective means for issuers to raise capital, especially small and medium-sized enterprises (SMEs), while ensuring the necessary level of investor protection,” says Charlie Malone, partner, corporate, commercial and securities law, with Wildeboer Dellelce LLP in Toronto. The new exemption contains requirements for information disclosure by issuers, which are designed to protect investors.

The OSC’s action follows a collective agreement made on Oct. 29, 2015, with regulators in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan to harmonize exemption requirements. As a result, these five regulators amended their existing rules to bring them in line with Ontario’s. The rules will take effect in these provinces on April 30, pending ministerial approval.

OM exemptions that exist in British Columbia, Manitoba, Prince Edward Island and the Territories remain unchanged, meaning that there will be two forms of exemptions across the country, says Barbara Hendrickson, CEO and founder of BAX Securities Law in Toronto.

As a result, you should be aware of different provincial exemption and investor eligibility rules. In B.C. and Newfoundland and Labrador, for example, these rules are less restrictive than those in Ontario.

Under Ontario’s new rules, the total cost of OM-based securities that an eligible individual can acquire within a 12-month period cannot exceed $30,000. However, eligible individuals who have received advice from a portfolio manager, investment dealer or exempt-market dealer on the suitability of such investments can invest up to $100,000 a year.

(An eligible investor is someone whose net income before taxes exceeds $75,000 – or $125,000 combined in the case of an investor and spouse – in each of the two most recent calendar years and who reasonably expects to exceed that income level in the current calendar year; or an individual whose net assets exceed $400,000. An ineligible individual – someone whose income and assets lie below those thresholds [a.k.a. an “average” retail investor] can invest up to $10,000 a year.)

The existing rule that allows accredited investors (which permits individuals who meet criteria for being designated an accredited investor, or a family member, friend or business associate) to invest in OM securities remains in effect, says Dunne: “These investors can invest an unlimited amount.”

In Ontario, an individual qualified to be an accredited investor must:

– own financial assets of more than $1 million, net of liabilities; or

– have a net income before taxes of more than $200,000 in each of the two most recent years, and have a reasonable expectation of exceeding the same net income level in the current year; or

– have combined net income before taxes with their spouse that exceeded $300,000 in each of the past two years and have a reasonable expectation of exceeding the same net income level in the current year.

Ontario’s new OM exemption imposes additional continuous disclosure requirements on issuers. Previously, non-reporting issuers were not required to provide disclosure on an ongoing basis, says Malone. But, given the potential for increased risk to investors who purchase securities under the exemption, he says, issuers now have to meet new ongoing disclosure obligations.

Under the new, harmonized OM requirements of the bloc led by Ontario, issuers now must file OMs with the appropriate securities regulator in a form prescribed by the OSC, together with any marketing materials used in the distribution process, thus making the documents part of the public record. However, OMs will not be subject to regulatory review prior to the completion of an offering. In the past, Hendrickson notes, issuers were not permitted to include marketing materials in an OM.

Given that OMs now must make reference to any marketing materials used for distribution, says Malone, such materials will be “subject to the same statutory liability for misrepresentation as the offering memorandum.”

In addition to an OM, exempt-market issuers must provide investors with audited financial statements and detailed issuer information during the distribution process. As part of the ongoing disclosure requirements, investors must be given audited annual financial statements accompanied by details of the use of proceeds raised through an OM.

Issuers in Ontario, New Brunswick and Nova Scotia must notify investors within 10 days if discontinuing the business, changing industries or of a change in control of the issuer’s ownership.

All investors in Ontario currently must sign a risk acknowledgement form that indicates that they are aware that they could lose a part or all of their investment when investing in an OM. Now, they must complete two more forms: one confirming their investor status – that is, whether they’re an eligible, non-eligible or accredited investor, or whether they qualify under the family, friends and business associates exemption; in the other, the investor must confirm that they’re complying with the investment limit to which they are subject.

The new exemption levels in Ontario provide investors with a new right of withdrawal from an OM investment within two business days and the ability to take legal action if there is misrepresentation in the information contained in the OM.

The increased costs incurred and time spent complying with the new Ontario rules may make the OM exemption significantly less appealing to many early-stage SMEs, Malone says

However, Hendrickson suggests, most issuers already meet many of the new requirements; thus, they won’t be a burden.

Dunne argues that the new requirements are a leap forward for issuers that want to be “respectable and distinguish themselves in a credible way.”

In the March issue: Helping clients understand exempt-market securities and how they might fit into a portfolio.

the first of three articles in a series on exempt-market investing

© 2016 Investment Executive. All rights reserved.

The new rules that have opened the exempt market to retail investors also offer enhanced investor protection

By: Dwarka Lakhan

Investing in products offered through the private capital markets is much easier now for retail investors in many provinces. That’s largely due to changes to the offering memorandum (OM) prospectus exemption rules, designed to provide small and medium-sized businesses with greater access to capital.

But clients who are accustomed to investing in traditional, prospectus-based products that are subject to greater regulatory rigour and disclosure could be entering unfamiliar territory because prospectus-exempt products carry different – and potentially greater – risks.

New disclosure requirements for OM securities that accompany the rule changes are designed to mitigate those potential risks.

Under the new rules, the average retail investor can invest up to $10,000 a year in OM products. Eligible investors, on the other hand – those who meet stipulated income and asset thresholds – can invest up to $30,000 on their own and up to $100,000 if they receive advice from a portfolio manager or dealer regarding the suitability of the investment. This rule change does not affect accredited investors or those who are family, friends and business associates of OM issuers (who can invest an unlimited amount).

The new OM exemption rule took effect on Jan. 13 in Ontario and is expected to become effective on April 30 in Alberta, New Brunswick, Nova Scotia, Quebec and Saskatchewan.

Among the risks that OMs carry:

– Liquidity. This risk can arise because investors typically cannot redeem or sell the majority of OM products at will. These investments generally have a hold period, which could be a year or longer; furthermore, a viable secondary market may not exist for a particular security.

“Once you’ve pulled the trigger and made your investment, you have an indefinite hold,” says Charlie Malone, partner in the securities law practice at Wildeboer Dellelce LLP in Toronto.

– Startup and size of issuer. The failure rate for startup and small companies tends to be greater than for larger, more established firms.

– Lack of information. OM securities are not subject to the same reporting standards as public issuers are.

– Suitability. The investment product might not be suitable for a particular client.

– Management. The lack of experience or track record in running a small business can result in a higher incidence of failure for an issuer – depending on the type of product and the size and reputation of the issuer.

“The problem is, prior to the rule change, OM products were perceived to be much riskier [than prospectus-based products], and that perception remains in spite of the shift to greater disclosure,” says Ahad Ali, analyst with Octane Capital Inc. in Toronto.

Malone says that products of reporting issuers are seen as being less risky than OM products because reporting issuers’ products have a disclosure record that is vetted by a securities commission – the Ontario Securities Commission (OSC), for example. However, although OMs are filed with the regulators, there is no requirement that OMs be reviewed.

But Craig Skauge, president and founder of the Calgary-based National Exempt Market Association, suggests that “it is a misconception that the regulators will not review OMs.” He says that regulators reserve the right to conduct reviews when necessary.

Investor advocates suggest that the perception of greater risk in OM products may have something to do with past issues of non-compliance with existing rules. For example, the Toronto-based Canadian Foundation for Advancement of Investor Rights (a.k.a. Fair Canada) noted, in its submissions to the OSC in June 2014 prior to the implementation of the rule changes, what the investor advocate described as the existence of an “unacceptable level of non-compliance” with OM exemption rules in the past.

This characterization is contested by Skauge, who says that there is “no huge evidence of non-compliance,” as highlighted by Fair Canada.

Nonetheless, recognizing the potential for greater risk with OM investments, regulators have introduced measures to allow for greater investor protection, Malone says.

For example, OMs must be filed with the regulators in a prescribed format, together with any marketing materials used in the distribution process, all of which become part of the public record.

In addition, issuers must provide investors with audited financial statements and detailed issuer information during the distribution phase; and, as part of ongoing disclosure requirements, issuers must provide investors with: audited annual financial statements; details of the use of proceeds raised through an offering; and notice of discontinuing the business, changing industries or change in control of company ownership.

In addition, investors may withdraw from the OM transaction within two business days of making the investment.

Skauge says that these measures suggest that regulators have dealt with risks relating to inadequate information and ongoing disclosure.

Any misrepresentation by an issuer, he adds, can be subject to legal action by investors, with potential penalties for the issuer.

And, by placing limits on the amount of money retail investors can invest in OM products, the regulators effectively have capped the risk of loss of investors’ money, Malone says.

As well, Ali says, the different caps on OM investment are designed for investors who can bear the risk of loss associated with an investment, based on their personal risk tolerance or on the advice of an investment professional.

Ali notes that all OM investors are required to sign a risk acknowledgement form, “which indicates that they are aware that they could lose a part or all of their investment. The risk of suitability falls squarely on the shoulders of the professional making the recommendation.”

This is the final article in a three-part series on exempt-market investing

Part one: New investment options for your clients

Part two: Exempt-market investing limitations
 

© 2016 Investment Executive. All rights reserved.