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Invest Like the Canada Pension Plan

by Todd McLay

June 19, 2020

Why does the Canada Pension Plan Beat Your Portfolio?

Why does the CPP perform so well year after year? Well, the key is that it is professionally managed with a focus on long-term performance.Long ago, the managers of the CPP realized that the old 60/40 investment principle (60% equities / 40% bonds) was hopelessly outdated and completely ineffective in today’s fluid, complicated markets.

So, how have we at Precedence Wealth adjusted our thinking to invest like these historically successful juggernauts? It is all about understanding the options at our disposal and coming up with the best mix to fit each particular situation. In addition to developing specific portfolios that can emulate the CPP’s impressive risk-return ratios and steady income generation, we also recognize how important it is to educate our clients. That allows the investor to contribute to the discussion in a meaningful way to ensure we incorporate the full picture before designing the most efficient portfolio possible. And maximizing the portfolio starts with reducing purchase prices. If the whole idea is to buy low and sell high, we need to make sure webuy as low as possible, and one of the best ways to do that is by reducing the“liquidity premium”. Avoiding this added cost is one of the main reasons institutional investors are so successful.

Liquidity Premium

One of the key contributing factors to the price of a given investment is liquidity. Liquidity refers to how easily an investment can be sold. Publicly traded stocks and bonds can typically be converted to cash within days. However, in exchange for this convenience and peace of mind, the investor pays a premium. Private investments that are non-liquid - meaning they offer only very restricted windows when they can be bought or sold - do not charge a liquidity premium, resulting in a comparatively lower price.

Now, there is definitely a time and place for liquidity. But it is crucial to analyze your entire portfolio to determine how much flexibility is actually required. Then any portion that doesn’t need to be readily available can be invested in low-liquidity options that reduce cost sand increase net returns.

Here are 4 excellent investment vehicles used by institutional portfolios that are also available to individual investors:

1.   Private Mortgages

Private mortgage investing is quite popular among sophisticated investors because they avoid the daily fluctuations inherent in similar public holdings. Because they are private instead of “market to market”, they lack liquidity but are backed by real property, feature very little volatility and provide high interest returns, usually in the 8-12% range. As first payor loans, they resemble publicly traded fixed income securities but offer far greater returns.

2.   Private Real Estate

Historically, real estate is one of the greatest wealth creators of all-time. However, owning property directly can be complex and involves commissions, closing costs and property management fees that can eat into your overall profit. Because of that, many people instead invest in Real Estate Investment Trusts, or REITs, which simplify the process while still allowing for the ownership of hard assets.

A key advantage is “economies of scale” – meaning the costs associated with real estate ownership are spread out over many investors and properties, reducing the costs for each individual. For example, rather than having one manager for one property, there can be one manager looking after multiple properties. A second benefit is that REITs can be owned within registered funds (RRSP, TFSA, RESP, etc.), something that is not allowed for direct real estate holdings.

Unfortunately, there are a couple downsides to public REITs.Because they are traded on the open market, they include a liquidity premium and also tend to be extremely volatile. Private REITs, on the other hand, are relatively non-liquid but are priced lower as a result. Also, since their value is based strictly on the underlying asset and not the whims of the market, they produce more consistent returns with far less volatility. Which is why institutional investors have long understood that private REITs are an important holding to help maximize returns and crete consistent growth.

3.   Private Equity

If you were to ask ten people who is the wealthiest person they know in their community, probably nine of them would name a private business owner. Private equity has long been the most direct path to personal wealth in Canada.The most successful private businesses involve a small, tightly knit group of shareholders, employ a long-term approach and consistently reinvest a large percentage of their profits back into the business to facilitate growth and maximize the company’s potential. These characteristics produce highly efficient businesses that are very effective at creating long-term wealth.

Private equity offerings, therefore, provide the investor with many of the advantages of owning an efficient business without the full time and money commitment. And, despite all these advantages, most private equity investments are still priced much lower than their public counterparts because of – you guessed it – the liquidity premium. Private equity requires more due diligence and is not easily traded but, as a result, there are greatdeals to be had to significantly improve the performance of your portfolio.

4.   Private Debt

Different than private mortgages, these debt vehicles are privately negotiated loans that exist outside standard banking networks. They generally focus on lending to companies with strong historical performance that value capital preservation and offer lower leverage ratios and more security.Sometimes very good companies have complex borrowing needs, or perhaps an incentive to raise capital faster than they could through traditional means.For example, they may need to fill an unusually large order, meet certain deliverables or increase their overall manufacturing capabilities. As a result,they might offer a much higher interest rate than normal in order to entice investors.

This can include asset-based lending - where the debt is tied to specific properties such as inventory or machinery - or “factoring”, in which those assets are not directly tied but are still used as a form of collateral. In either case, the investor has the same (or sometimes greater)level of protection but hold an asset that, once again, does not include a liquidity premium and is not as volatile because it is not accessible on the public markets.

NextEdge Capital Private Debt Fund is a perfect example of this and is a fund we have had great success with over the years. It has proven extremely stable, averaging 0.5% per month without any negative pressure on the underlying asset value. Investments like this are crucial contributors to portfolios that produce solid returns without unwelcome correlation to the stock market.

Conclusion

The CPP is one of the most recognizable and productive institutional funds in Canada and their success is based on holding private,alternative investments that grant them access to inefficient markets within our economy. They focus on long-term growth targets that are not burdened by liquidity premiums. Implementing this strategy in your own portfolio can help you generate good, tax-efficient returns with very little volatility, which should be the goal of every smart investor.

The world of modern investing is diverse and complex. The options available to a knowledgeable investor are practically endless, covering the entire spectrum of risk from safe or guaranteed to volatile and unpredictable. Each with their own risk/return ratio, income style and liquidity level. Why, then, with all these alternatives, does the average portfolio perform so poorly in comparison to large institutional funds such as the Canada Pension Plan? There was a time when it could be blamed on a lack of private options, but that certainly isn’t the case anymore. No, these days, the only things keeping you from matching the profitability, efficiency and consistency of these big funds are a lack of expertise and imagination.

Which is exactly why choosing the right financial advisor is so important.

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