Interest in alternative investments has grown as investors seek to diversify their portfolios and increase their returns. This asset class usually refers to instruments outside the three major “traditional” types: cash, bonds, and stocks (although there is a grey area regarding some mutual funds, ETFs, and derivatives).

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This broad category of investment includes commodities (metals, oil/gas, etc.), private equity and venture capital, real estate (land, REITs, MICs), hedge funds and physical assets (art, wines, even baseball cards). It expands when new products, such as cryptocurrencies, emerge and gain acceptance.

The main reason to include alternatives in a wealth management portfolio is their low or even negative correlation with traditional markets. Most institutional investors, such as banks and pension funds, have a small portion of them in their holdings. When it comes to individuals, however, access to these products has been pretty much exclusive for people known as qualified or accredited investors. Even though there is a trend to make them more accessible, the nature of these assets will keep many of them restricted.

Qualifications for accredited investors vary across Canada since they are regulated by each province. Generally, accredited investors must either have a minimum level of income (for example, pre-tax $200k for two consecutive years for an individual or $300k with a spouse) or possess a minimum net worth (for example, $5 million net assets, either individually or with a spouse). There are more details that we cannot cover here, but it should be evident that accredited investors are mostly found in the higher net worth tiers. The rationale for this restriction is that such individuals are assumed to be knowledgeable and, more importantly, can stake capital in longer-term, riskier opportunities, without suffering major financial distress in case of a loss.

In Canada, a large portion of alternative investments, especially those involving equity, are included in the Exempt Market (EM). According to the Ontario Securities Commission, “The ‘exempt market’ describes a section of Canada’s capital markets where securities can be sold without the protections associated with a prospectus.”

“When used strategically within a portfolio, these products will improve diversification.”

A prospectus is a formal document with detailed information about the security to be issued so investors can make an informed purchase. It must be filed with the provincial securities commission for approval. It is illegal to issue securities without a prospectus unless the authorities grant an exception. They do so to facilitate access to capital for companies (many of them small or medium) that lack the financial and legal resources to navigate the conventional process. This, in turn, promotes economic growth. In many EM issues the prospectus is replaced with a less comprehensive offering memorandum.

But why are exempt investments riskier than traditional ones? We can highlight three main reasons. First, disclosure requirements are stricter under a prospectus. The issuer must make public announcements of material changes and is obligated to provide constant information. This requirement does not apply to the EM. Second, investors have more legal protections in the traditional system. For example, they can sue for damages if the issuer is found guilty of misrepresentation. There is no such protection in the EM. A third difference is that of liquidity. Conventional securities can be resold without restrictions in the secondary market (for example, a stock exchange), where there are plenty of buyers. EM securities do not trade freely, and, in some cases, can only be resold at a heavy discount if authorized. Investors in the EM are required to acknowledge, in writing, that they understand and assume the risks in the offering, including the potential loss of their entire investment.

While this might discourage some people from considering the EM, this need not be the case. When used strategically within a portfolio, these products will improve diversification. And they can offer exceptional returns. Fortunes have been made with successful technology startups. Another example is real estate developments that reward patient investors who wait for the big payoff.

The key is to use alternatives and EM products within a carefully constructed investment plan, and always with the expertise of professional advice.

For those who want to learn more, check out the Private Capital Markets Association (PCMA).

Legal Disclaimer: the contents of this article are for information purposes only and are not intended to provide any form of financial or investment advice.