December 2016

OPPORTUNITIES FUND

  • +0.45% (Class A)
  • +0.52% (Class F)

CAPITAL INVESTMENT FUND

  • +0.92% (Class A)
  • +0.95% (Class F)

2016 is in the books.  Both of our funds made it through the year on the positive side of flat, marking a combined 14 years without a negative return year.  A fact we continue to be very proud of.  I'll leave the details of fund performance and market outlook to Julian and his quarterly write up to investors, which is below.

Sincerely,

Jai Hawker

Capital Investment Fund

RSCIF units gained 0.9% in Q4 of 2016 and 1% for the year.  Trailing annual volatility for the Investment Fund was 2.8% and its correlation to the S&P/TSX Composite Index was -0.08%. 

The Investment Fund made 12 new investments during the quarter, including 8 structured product arbitrage, 1 relative value arbitrage, 2 volatility and 1 merger arbitrage investments, while exiting 28 investments.  At the end of the quarter, we were monitoring 134 redeemable structured products with total market value of $7.2bn ($55mm average size).  The Investment Fund ended the quarter with 32 structured product investments.

Gross exposure (long + shorts) of RSCIF was 90% as at quarter end, with approximately 61% of the portfolio invested in the structured products arbitrage strategy.  The reduced gross exposure for the Fund was due to an abundance of structured product retractions at year end.

Our structured product arbitrage strategy gained 0.5% in the quarter.  The risk arbitrage strategy gained 0.3% in the quarter, led by St Jude, SiriusXM Canada and the Algonquin installment receipts.  The multifactor and volatility strategies were approximately flat.

Opportunities Fund

RSOF units gained 1.5% in Q4 of 2016 and 1.6% for the year.  Trailing annual volatility for the Opportunities Fund was 6.4% and its correlation to the S&P/TSX Composite Index was 0.04%. 

The Opportunities Fund made 17 new investments during the quarter, including 8 merger arbitrage, 5 relative value arbitrage, 3 high yield investments and 1 liquidation, while exiting 11 investments.  At the end of the quarter, we were monitoring 108 risk arbitrage situations globally with total market value of over $950 billion.

Gross exposure (long + shorts) of RSOF was 154% as at year end with the portfolio split equally between Canada and the US.

Q4 Fund performance was driven by the merger arbitrage portfolio with a 1.5% return, followed by the high yield debt strategy, which added 0.4%.  The special situations and liquidation portfolios were both down 0.2% while the relative value strategy was roughly flat.

We are pleased with the positive performance of our merger arbitrage strategy.  This positive performance came despite the most difficult investing environment since the global financial crisis.  According to the New York Times, 1,009 deals worth $797 billion were pulled in 2016, the most since 2009.  Hence the importance of our diligent research process and fundamental security analysis.  In the fourth quarter, Apollo Education, SiriusXM Canada and QLT were positive performers, slightly offset by InterOil which traded off on a deal delay.

A friendly takeover from Chemtrade led to the appreciation of our Canexus convertible debentures, contributing to positive performance for our high yield strategy.  Within our relative value strategies, the Dell Technologies tracking stock discount continued to tighten.  However, we still see material upside given its 30% discount to intrinsic value.

Outlook

While both funds provided positive returns with low volatility, the mediocre returns achieved in 2016 are below our target. One reason we underperformed this year is because not only did we find fewer high reward / low risk opportunities, but a highly abnormal amount of investments did not turn out as planned.

In the past five years we’ve never seen a bond redemption cancelled – we had two this year.  We’ve never seen the government invent new regulations exclusively to block a deal – which happened to us on Allergan (a large position for the Opportunities Fund).  We’ve never seen a company ignore a 20% superior proposal in an M&A situation and rush through a lower bid, which happened to us on Pacific Safety Products.  We’ve never seen an M&A deal trade to a 50% premium in a short squeeze and then close successfully a month later, which happened to us on QLT / Aegerion (this breaks all the rules of a supposed rational market).  We’ve never had a structured product retraction come in 7% lower than expected.  We’ve never seen a stock lose the majority of its value in a liquidation, as we saw with Legumex Walker.  We’ve never seen so many undervalued securities with near term catalysts have these catalysts occur and their stock prices just languish (this could be due to hedge fund crowding).  Many of our strategies just didn’t work as well this year.  We truly believe these were one-off abnormal events in the cycle, and are not part of a secular trend.

On a positive note, our strategies have a bright outlook.  US interest rates have recently hit 5-year highs.  Higher rates are very beneficial to our short duration, yield-based arbitrage strategies.  This is because arbitrage spreads are priced off of the risk-free rate.  The higher the risk-free bond yield, the higher the arbitrage spread.  Higher rates also provide for a higher return on the short side of our portfolios, due to the higher yield on our cash and lower short borrow fees. 

Both RSAM funds now have 5-year, or greater, track records of success. In total, RSAM has provided investors with a total of 14 years of positive returns with no down years across two funds.  We are proud of this accomplishment and we’d like to thank our investors for their trust and commitment.   

Avoiding losses is our primary goal.  Through stringent risk management and adherence to low-volatility investment strategies, the upside tends to take care of itself.  But for some investors, focusing on avoiding losses becomes difficult when other investors with directional strategies have already partaken in a market surge and have been rewarded for speculation.  We have seen this recently, as the TSX has been propelled by a speculative fervor in many low-quality resource stocks, many of which have appreciated markedly.  Trees don’t grow to the moon, and speculative stocks experience downside volatility too. 

While in 2016 risk management was a fool’s errand, we believe that a conservative investment strategy is appropriate for the current environment.  The TSX is trading at 23.6x earnings, which is the highest valuation of Canadian stocks in 14 years and 26% above its 10 year average.  As valuations have surged, the upside risk has diminished while downside risk has grown.

As always, we continue to work harder (and smarter) than ever to generate low-volatility absolute returns through the cycle for our investors. 

Julian Klymochko, CFA 

Paige Knight