Early on in this crisis, I hadn’t made up my mind about whether those arguing for the closing of the public equity markets deserved some proper consideration or not. After all, everything else was closing down so why not the exchanges themselves at least until we get some clarity on the economic consequences?
Then I realized just how bad of an idea this was especially after looking at how those areas of the market such as Canadian private equity, debt and mortgages are behaving in this current environment.
The beautiful thing about investing in public markets is you get full transparency on pricing and more often than not liquidity isn’t an issue, as long as you stick to the larger company stocks and/or ETFs. This doesn’t mean that markets get it right all of the time as they are notorious for incorrectly pricing forward expectations.
However, this can create opportunities for those willing to take advantage of any mispricings as they occur while providing a powerful lesson for those who give into emotion and buy the tops for fear of missing out or sell the bottoms on loss aversion. At least for the most part, investors can get their money out and redeploy into other areas of the market in order to recoup losses from any mistakes made.
Fast forward to today’s situation, where public markets are still trying to price in the forward risk from the fallout due to the coronavirus, with pundits unsure whether assets are over-, under- or fairly valued. As a result, there are large daily swings until some level of this uncertainty begins to dissipate.
For those arguing for a market closure until there is some better forward visibility, we think it’s worth having a look at those less transparent segments, such as the private debt and mortgage markets, to determine what the trade-offs are.
Ironically, because of their assets not being marked-to-market on a regular and consistent basis, many private funds have been reporting a linear return profile that consequently offers a so-called “low correlation” to the traditional portfolio.
This works until a large event happens like this one sending the mortgage market into complete chaos and putting asset prices very much at risk.
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To add some perspective on just how dire the situation is, almost half-a-million Canadians have requested mortgage deferrals and skipped payments in just the past two weeks alone, according to a Canadian Bankers Association report. In total, the country’s six largest banks have deferred more than 10 per cent of the mortgages in their portfolios. So ask yourself, how are the smaller private mortgage and debt investment corporations going to fare in this type of environment?
While there is plenty of disclosure on the depth of the situation in U.S. private-debt markets, surprisingly we’ve heard little of this in Canada despite our shadow banking market being valued at over $1.5 trillion and representing 10 per cent of total financial assets, according to the Bank of Canada. The closest thing we have is Canada’s public REITs, which have sold off by nearly 30 per cent this year while higher-risk publicly listed lenders like Home Capital Group and Equitable Group are down 50 to 60 per cent — something to keep in mind when looking at your private fund’s net asset value on your quarter-end statement.
On the contrary, if this were a public market with full transparency there would be differentiation between the good private debt managers and the bad. Investors could finally have the ability to research the quality of investments and managers of these funds and make the appropriate reallocations into those with assets able to withstand this meltdown, and selling those that will likely not survive. If the good funds were oversold perhaps this would even be a good buying opportunity for those underweight real estate in their portfolios, which we think is a great diversifier.
That said, none of this really matters as those markets are essentially closed, liquidations are likely gated and it’s a toss of the dice on what those valuations will ultimately look like in the months to come. If this is what happens if equity markets were ever closed, then it really is a terrible idea after all.
Martin Pelletier, CFA, is a Portfolio Manager at Wellington-Altus Private Wealth Counsel Inc. (formerly TriVest Wealth Counsel Ltd.) a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax and estate planning.