The Pros and Cons Of Living An Alternative Lifestyle: Do Exempt Market Investments Have A Place in Your Portfolio?

Whether your traditional investment portfolio is constructed from individual stocks and bonds, mutual funds, Exchange-Traded Funds (ETFs) or any new market-based investments, there is one inescapable reality—your holdings will be subject to the whims and fluctuations of the stock market. And that is not necessarily a bad thing if the gods of investing smile kindly upon you, particularly if you have a properly diversified portfolio suitable for your appetite for risk, time horizon and stage of life. If this sounds like you, then 2025 was probably a banner year.

Yet, regardless of whether you are an active trader, indexer or dividend hound, volatility will not always be your friend, and sprinkling the appropriate backstop of bonds into your portfolio isn’t always guaranteed to save the day. Moreover, in times of low bond yields that pay heavily taxed interest when held in an open portfolio, bonds can be a heavy drag on both pre-tax returns and, far more importantly, on how much is left after you pay our friends in Ottawa. Guaranteed Investment Certificates (GICs) may avoid market volatility but often don’t offer investors any growth in their savings after inflation and taxes. Yes, there has been an explosion of new types of investments, including the new generation of covered call funds, principal-protected and principal-at-risk notes and liquid alternatives, which can use a variety of complex strategies to make you money and mitigate risk, and which are readily tradable. But today I want to talk about an entirely different class of investments—exempt market products.

Personally, I think of most “exempt market investments” as owning pieces of private businesses that do not trade on any stock exchange, although some of them might aspire to do so someday. Just as there seems to be an almost infinite number of companies trading on stock markets, there is also a vast array of non-market investments. The most common are real estate-based, either mortgage investment corporations (“MICs” to those in the know) or private Real Estate Investment Trusts ("REITs".) Even within those two classes of investment, there is a large range of options at different levels of risk. Want to stick exclusively to first mortgages? There are MICs that specialize exclusively in those. Willing to dabble in second or third mortgages? There are funds that do just that. Want to use leverage to boost returns? What about lending to homeowners vs. developers? Do you want to target a specific part of Canada or even lend abroad? There are options for all of this.

The same is true for private REITs. Just like there is a wide variety of REITs that trade on the public market, there is likely a private REIT that does the same thing. Whether you want to focus on industrial, commercial, multifamily, self-storage, car washes, farmland or hotels, you will likely be able to find something right up your investment alley. And that just covers real estate-based investments. There are many other options available. For example, I own a consumer lending fund, a fund that owns shares in a fungicide company, a fund that owns a basket of smaller-sized private businesses too small for the hedge funds and I made a private high-interest loan to a nursing home company, to name a few.

Finally, the size of exempt market funds varies dramatically. Some are valued in the billions (yes, you read that correctly), while I’ve seen some as low as $25 million, although I suspect that some are even smaller.

But rather than simply telling you about what you could buy and the size of different funds, it is far more useful to learn more about how the exempt market works, how people get paid and both the pros and cons. Like when picking publicly-traded stocks or funds, there are investments that make early retirement more than a dream and others that will break your heart. And, also just like a traditional portfolio, a healthy diversified mix of exempt market investments that matches your needs, risk level and time horizon is the best recipe for success. 

Basics Of The Exempt Market

It might shock you to know that most pension funds, including the Canada/Québec Pension Plan (CPP/QPP), can own more than 40% in non-stock market investments. The same is true for many university endowment funds and family offices. It is now possible for the general public to tap into this asset class. Admittedly, there are often better returns and lower fees for investors with deeper pockets, but the same is also true when investing with investment companies and with portfolio managers. While the wealthy may still get a better deal than Joe or Jill Blow, there is still the possibility of healthy returns for the average person with the right mix and, as always when talking about investing, a little good fortune.

How To Buy In

The public most often needs to purchase exempt market investments through an exempt market advisor, who must be regulated and licensed to trade these investments. The advisors typically are associated with Exempt Market Dealers (“EMDs”), which are firms that work with the companies and funds that are looking for investors. The EMD investigates and vets the opportunities that are available (“the offerors”) and decides which ones are worth adding to their shelf of products. The EMDs effectively help the offerors market their services and sell their products through their army of exempt market advisors and their clients. The offerors generally pay a healthy commission, which the advisors and EMDs share, along with potentially referral fees that advisors also pay to people who introduce the clients to the advisors in the first place.

On the other hand, old school investment firms are now starting to stock exempt market funds on their shelves, either through products they create themselves or by selling offerings traditionally only available through EMDs. Investment firms vet exempt market offerings in the same manner as EMDs, although they typically don’t collect the same upfront commissions paid to exempt market advisors. That said, however, most traditional investment houses have a very limited selection of exempt offerings. Moreover, some offerings are exclusive to specific EMDs, although it is also true that some products are available through multiple EMDs and traditional investment firms. Ultimately, I have purchased different exempt market offerings from a variety of EMD advisors and mainstream portfolio managers. In the end, while it is still possible to do one-stop shopping with a single exempt market advisor or portfolio manager, that person won’t have access to the entire universe of exempt market products. 

Who Can Purchase Exempt Market Products?

One of my pet peeves is that anyone can easily open their own self-directed trading account and put their entire worldly wealth into a single penny stock recommended by their best friend’s uncle’s wife’s hairdresser, regardless of their financial circumstances, investment knowledge or time horizon, by simply pressing a few buttons after chugging down a few beers. On the other hand, there are restrictions based on wealth and income on who can purchase exempt market offerings and, unless you’re uber wealthy, how much you can buy relative to your total net worth. Moreover, anyone doing so, regardless of their degree of risk associated with the offering, will first have to itemize their entire financial background and, if approved for a specific investment, sign a package of acknowledgement forms longer than most Shakespearean dramas that include the warning that they might lose their entire investment. While I applaud “know your client” regulations and requirements that advisors sell exempt market investments only in the amounts and types that make sense for each client, restricting who can buy certain investments by minimum income or net worth seems a little too “big brother” for me, and the amount of paperwork involved seems like a drastic case of overkill.

This is where working with a portfolio manager at a firm with a good selection of exempt market investments can make a huge difference. Even if you don’t have the income or net worth to qualify for specific investment market investments on your own, a portfolio manager or “PM”, is able to purchase them on your behalf. They will need to ensure the appropriateness of, and the right size of each investment, but that’s how they manage your publicly-traded investments as well. Moreover, as an added benefit, they typically do not receive any additional compensation from the offeror for selling exempt market products, which removes conflict-of-interest concerns. When combined with a PM’s extra qualifications and fiduciary duty to clients (a fancy way of saying that they always must put clients first, which may not be required of all investment advisors), getting exposure to the exempt market through your PM is a good starting point for many investors.

On the other hand, many PMs have a limited number of exempt market investments on their shelves. While your PM may be able to place you in a good exempt market investment, an exempt market advisor might have access to something even better. As well, working with the right exempt market advisor who only lives, eats, and breathes exempt market investments might provide you with better insight into specific investments than a PM who is also responsible for knowing and managing a multitude of publicly-traded investments. Accordingly, whether you would benefit the most from working with a PM or an exempt market advisor, or both, really depends on the people involved and your personal situation.

Compensation And Fees

As is the case with traditional investment advisors, there are several different ways that advisors selling you exempt market products might get paid. Here are the most common:

• Commission: Some offerings pay advisors a one-time commission out of their own pockets, which might be the only payment your advisor receives. The commissions range in price, and it is common for exempt market advisors to share a portion of their take with people who referred the clients their way. This referral agreement must be fully disclosed to the investor and acknowledged by them prior to investing.
• Trailer Fees: Some products pay advisors an annual fee based on how much that client has invested in that product, either for the life of the investment or for a specific period of time. This is similar to how many mutual fund advisors are paid.
• Advisory Fees: Traditional advisors who offer exempt market products often sell a separate class of that offering with the trailer fees stripped out (and therefore pay more to clients) but charge clients a fee based on the size of their portfolios. It is common for these fees to be tiered so that if your holdings are above a certain size, you pay a smaller percentage fee on investments above that threshold. For example, there might be a fee of 1.5% on the first million, 1% on the next $2 million and .75% on the excess. Unlike the other fee options, clients pay this fee to their advisors directly. Accordingly, they need to mentally subtract these fees when looking at the target returns of any exempt market offerings. 

There are also often additional fees and charges that the offeror charges as part of that product’s offering expenses in the same way that mutual funds charge annual fees on top of what they might pay advisors. In addition to yearly management fees, some funds might charge a fee for finding or selling real estate or similar holdings. It is also common for some funds to claim a share of the upside. For example, they might offer clients a “preferred return” of 8%, where investors get 8% of the net profits after deducting other fees and costs, but any subsequent profits are split 80/20 in favour of the investor. Some funds even have “catch-up” payments. For example, using the previous scenario, some funds offering an 80 / 20 profit split might pay investors the first 8% in profits, keep the next 2% until they have “caught up” on their 20% split and then divide any profits over 10% on an 80 / 20 basis. Ultimately, each fund is different, and it is important to understand how both your advisor and the offeror are getting paid before you make any decisions. While I have no problem with others making good money from my investments if I do as well, I want to understand the fine print and how it might affect my returns before I invest.

Downside Of Exempt Market Investments

In addition to knowing how everyone gets paid, it is also important to know some of the other potential drawbacks of exempt market investments. Here are some of the big ones:

A. Lack of Transparency

Unlike individual stocks, ETFs or mutual funds, your investments are not valued daily. For evergreen funds (investments that do not have a specified windup date), the value may be updated a few times each year, but for other investments, particularly project-based ones that plan on selling off the investment at a set date, the actual value may not be determined until that time. On a similar note, fund updates will likely be only a few times per year at best, unlike public market investments, where there may be updates, no matter how minor or inconsequential, on a daily basis.

Exempt market investments are monitored by the EMDs that sponsor them, and those with bank debt are also regularly monitored by the lending institutions. They typically file audited third-party financial statements each year, and some have an independent board of directors designed to further keep an eye on things. Moreover, even though they are called “exempt market investments,” this does not mean that they are exempt from all regulatory oversight. It just means that they are subject to a different set of rules than investments that trade on the TSX. That doesn’t mean that there aren’t a few crooks who’ve run exempt market funds, but as anyone who invested in Bre-X or Enron can tell you, there are some fraudsters managing publicly traded companies as well.

B. Lack of Liquidity

While you can sell your stocks, mutual funds or ETFs daily on a whim and get paid a few days later, this isn’t typically true in the exempt market world. Some (but not all) offerings require investors to stay invested for a minimum period, such as 3 years, or pay a penalty if they want to exit early. Some investments, typically the project-based ones, may not offer early exits at all, which might mean having to wait the full 5 years to get cashed out. Moreover, there are no guarantees that you will be paid even then. One of the reasons that I am now reluctant to invest in most project-based investments is that I am still the not-so-proud owner of a few ventures that are now several years past their sell-by date. For investors with a shorter time horizon, this can be catastrophic.

Moreover, some funds may restrict how many investors can redeem within a set period or even shut off redemptions (called “gating” by those in the know) periodically if there is a rush of people trying to get their money back at the same time. And, even under normal circumstances, redemptions are often only available monthly (and sometimes less frequently), which can ultimately mean having to wait closer to 2 months before getting cashed out. Moreover, there might be restrictions on how many people can redeem at a time, even if a fund isn’t officially “gated.”

C. Early Redemption Fees

Finally, if you want to sell some investments within a set timeframe, you may need to pay a penalty in the same way that investors used to have to pay a penalty if owning deferred sales charge mutual funds. These fees decline over time but might take 3-to-5 years to disappear completely. Moreover, project-based funds that are designed to wrap up at a set time might not be able to fairly value what the underlying investment is worth early on, particularly in the first few years, while they are still paying many startup expenses, including the commission paid to EMDs and their advisors. Accordingly, investors exiting early might pay a substantial price for doing so, both by paying early redemption fees and selling at a valuation that might be lower than what they paid. If investing in such a fund, realize that you are in it for the long term and be sure to budget a few extra years beyond the target wind-up date.

D. Holding Costs

Although it doesn’t matter if you are working with a portfolio manager, if you are working with an exempt market advisor, you will likely need to open separate investment accounts with institutions that specialize in holding exempt market assets, particularly if you open registered accounts. They often charge annual fees, plus additional amounts with every purchase or sale, which can add up over time. For smaller investors, it is important to understand these costs and how to manage them so they don’t eat into too many of your profits, as well as taking these costs into account when deciding whether to invest in the first place.

As a side note, if opening a Tax-Free Savings Account (TFSA) with one of these institutions, I suggest setting up your account to pay any fees through a credit card or non-registered money so that as much of the income and gains earned inside your TFSA remains to grow tax-free, as TFSA room is a precious resource.

Potential Advantages

After learning of the complexity of the exempt market world, the potential fees, liquidity restrictions and other potential problems, you may be wondering why you would bother investing in this market in the first place. While giving this investment class a hard pass might be the right answer for some of you, there are also reasons why other investors are still willing to take the plunge.

1. Potentially Higher Yields

Many yield-based exempt market investments offer high single-digit to mid-double-digit annual payouts, even after everyone else has gotten paid. For example, although most MICs are reducing their payouts due to interest rate cuts, they still offer substantially higher payments than GICs and government bonds. I own some other exempt market funds that pay between 12 to 17%, for example, although with no upside. I am comfortable with the products and how they are running their funds. Moreover, I love the thought of getting paid regularly rather than hoping for eventual capital gains and can either reinvest or “drip” the money into buying more units of that investment or invest it in something else.

Perhaps more importantly, for investors building for or enjoying their retirement, earning a healthy income means that if there is a market correction, they will not need to sell off any, or as many, stock market investments to pay their living expenses. One of the biggest risks for some retirees is something called “sequence of returns” that I’ve written about previously. In a nutshell, bad investment returns early in retirement that require investors to sell low rather than waiting until the market recovers can torpedo how much money is left to fund their retirement down the road. Having part of their portfolio into high yield investments that are not stock market-driven reduces how much of their traditional stocks and bonds they must sell to pay for coffee and cornflakes. Moreover, if these investments pay significantly more than GICs and bonds, investors continue to get better overall returns during the good times so that they have more of a buffer if things get bad, if their exempt market investment performs as anticipated.

On a similar note, some clients with children within a few years of university or who have already started their studies may like private MICs or similar private investments with steady but significant payouts. Although they will likely need to provide a couple months’ advance notice to access their funds, the size of their accounts when they need the money won’t be subject to stock market fluctuations and will likely be significantly larger than if invested in traditional public market fixed income investments. I’ve also used this strategy for clients saving for a first home or for mortgage renewal. For example, one client during Covid worried about a spike in interest rates when her 2% fixed rate mortgage was up for renewal in several years. Rather than making extra mortgage payments along the way with minimal impact, she invested in private MICs paying approximately 10% inside her TFSA. When it was time for renewal, she cashed in her TFSA and was able to dramatically reduce the mortgage balance without having to worry about the stock market interfering with her plans.

2. Diversification

While exempt market investments have their own set of risks and problems, they are often a largely different set of pros and cons than those that trade publicly. As a result, provided that the exempt portion of any portfolio is appropriately diversified and carefully chosen, investors may enjoy both better overall returns and less volatility than a traditional 60 / 40 offering of stocks and bonds. There is a reason why pensions and many High-Net-Worth (HNW) investors like to invest outside the stock market. Although they will always have more and better opportunities than you and me, that doesn’t mean that there aren’t some attractive offerings for us to also consider.

As noted earlier, real estate is the most common exempt market offering. Although it is possible for investors to purchase publicly traded REITs, publicly traded funds have the same volatility as other stocks, even if real estate prices are not affected. During the correction of 2008, for example, public REITs took it on the chin like other public investments. Private REITs in Canada, on the other hand, essentially treaded water that year, since the value of their underlying investments was largely unaffected. For the same reason that investors might want to buy their own separate investment properties, other investors without the same bank balances or who don’t see themselves as landlords may prefer to own private REITs rather than public ones.

On a similar note, I remember scheduling meetings with several new clients in Victoria, BC in February 2009, as the stock market hit its absolute bottom, and wondering how many boxes of tissue would be appropriate. Instead, much to my surprise, three sets of happy clients told me that they had invested their entire retirement savings in private MICs. Instead of absorbing the financial body blows that so many of us endured, they sailed through the crash unscathed. Although I don’t suggest that you follow in their footsteps, it does suggest that there is a potential place for non-stock market investments.

3. Tax Efficiency

As I tell my clients ad nauseam, it’s what you keep, rather than what you make, that matters. In other words, after paying all fees and taxes, how much do you have left to pay for a dinner and a movie with your main squeeze? Although eligible dividends from Canadian publicly-traded companies can be extremely tax-efficient for investors in lower tax brackets, they aren’t so advantageous for those with higher incomes, or those worried about Old Age Security (OAS) clawback. Some exempt market investments, particularly private real estate investments, might be able to help higher net worth investors keep more of what they make. Some can pay attractive “return of capital” monthly distributions to investors, which are treated like a tax-free return of some of their original investment rather than taxable income, deferring the tax until the investment is sold, at which time it is also taxed as capital gains. Moreover, some private REITs can pass along additional tax deductions that investors can use against other sources of income to reduce their total tax bill.

In contrast, most public REITs often do not pay out as much, and what they do pay typically includes a taxable portion, and do not offer these tax deductions. While private REITs generally carry higher costs and may force you to share some of the upside, they may still be able to offer a higher after-tax return in some cases if all goes according to plan for these reasons.

4. Greater Access To Management

Although exempt market investments may not have to share information in the same way as publicly traded stocks, some provide both regular updates and online meetings where investors can get information directly from the president or senior executives running their investment. Some exempt market advisors are also able to set up smaller meetings with the movers and shakers directly, so you have a better understanding of what you’re investing in, can get your questions answered directly from the horse’s mouth and decide for yourself if the person running a company or fund is someone you trust, and who knows what they are doing.

Gratuitous Advice From A Tall Guy

Prior to signing off, I wanted to also pass along some of my own suggestions if you do decide to invest in the exempt market.

• Be Wary Of Projects

Most project-based investments I’ve funded have run overtime and have caused considerable problems for investors. A great deal can happen from the time an investment is launched to its target windup date. It is asking a lot to assume that selling a project in exactly 5 years makes investment sense and even pushing things back a year or two might not materially change the math. Accordingly, I am reluctant to invest in anything that has a target windup date (although I have made exceptions). If I do invest, I make sure that I use funds that I know I won’t need for several years after I’m supposed to be paid out.

• People Matter

It is important to get a good feeling of both the person selling any investment and their expertise, as well as the people running that investment. Experience and knowledge matter. I like to work with people who have been around the block a few times and have taken a few courses along the way. That includes both exempt market advisors and PMs, as well as the people running the business I’m investing in. I want advisors who know the underlying investments, invest in them themselves and aren’t merely salespeople. For the people managing the actual investments, I want to know that they have the expertise to do what they say they will do and, even better, have done so successfully in the past. I do not want to be part of someone’s learning curve and am also careful about investing in brand-new funds where they might not have worked out all the initial kinks.

Integrity also matters. If you don’t have a good feeling after meeting with someone, despite their qualifications and expertise, it’s better to walk away. There are always other opportunities, and sometimes the best investment decision you can make is to just say no.

• A Little Skepticism Goes A Long Way

When reading the marketing material, remember that someone is trying to put their best foot forward. Ask yourself if the numbers are realistic and what might go wrong. It’s also a wonderful thing if the investment actually has a track record and you can see if it has met its promised returns in years gone by. I like investments that have a large margin of error before they are unable to pay me what they have promised or make the anticipated profits. I question assumptions and love it when I feel like the offerors have not based their calculations exclusively on what will happen in a perfect world.

I also keep a close eye on the fees and any profit split. I vastly prefer funds where the offerors don’t make any profit over their basic management fees until they have already made me a healthy return or have guaranteed me a minimum return. Unfortunately, the latter are not quite as rare as unicorns, but they are certainly not commonplace.

• Don’t Be Afraid To Dip Rather Than Dive

If you are new to the exempt market, it can make a lot of sense to start with smaller investments in more traditional real estate products that are easier to understand. I particularly like investments that are backed with tangible assets rather than merely good ideas. The more exotic and complicated investments can wait until later and might never be appropriate. Paraphrasing Warren Buffett, there is a certain benefit to investing in companies where you can compute the benefits of doing so on the back of a napkin rather than by listening to a spreadsheet presentation. There is nothing wrong with starting with a conservative MIC and taking a wait-and-see approach before deciding to dive into exempt market investments headfirst. And, if you do increase your exempt market holdings, avoid too much in any single product, and continue to own the appropriate portion of traditional securities; although owning some exempt market investments may be a good idea for the right investors, an overconcentration of exempt market funds can be too much of a good thing.

• Greed Isn’t Always Good

Be extra careful about investments that offer excessive returns, as you need to ask yourself why they are so generous and if the risks involved justify the potential reward. Ask questions and check their math carefully. And, if you do take the plunge, don’t dive in headfirst; limit the size of your investment to an amount you can afford to lose.

Conclusion

Although I think there is a place for the right exempt market investments in the right circumstances, that doesn’t mean that this asset class is a perfect fit for every solution. I’ve both made and lost money in the exempt market and, while I think I’ve learned a lot along the way, I remain both humble and wary. I would suggest that you do the same.

Colin S. Ritchie, BA.H. LL.B., CFP, CLU, TEP and FMA is a Vancouver-based fee-for-service lawyer and financial planner who does not sell investment or insurance, just advice. To find out more, visit his website at www.colinsritchie.com.