SEPTEMBER 2017

CAPITAL INVESTMENT FUND

  • +0.29% (Class A)
  • +0.30% (Class F)

OPPORTUNITIES FUND

  • +2.53% (Class A)
  • +2.60% (Class F)

Starting with the 2016 tax year, the RSAM funds will be flowing through tax allocations to our unit holders based on the way returns were generated within the funds (the majority of which will be capital gains and losses), rather than entirely as income as we have done in the past.  We are excited about this change and view it as a positive step forward in the evolution of our company and we endeavor to communicate with you as much as possible to avoid any confusion.  We are acting on the advice of KPMG, our tax advisors.
 
The distribution you receive this year will be larger than the NAV increase of the funds for 2016.  The majority of this difference is a result of the timing of certain trades within the funds and more gains than losses were realized throughout the year.  In other words, the size of the distribution is based on the taxable income attributable to each investor. Of course, due to the favorable tax treatment of capital gains, your tax bill will be much lower than the distribution you receive. As a continued unit holder of RSAM, the losses that were not available for tax purposes at the end of 2016 will be available for crystallization in future periods, at which point they will be used to offset capital gains and result in a lower future tax bill.   
 
If you are on the reinvestment plan, you receive additional units of the fund equal to the amount of the distribution divided by the post distribution NAV.  If you are not on the reinvestment plan but would like to be, please contact our Manager, Investor Relations Paige Knight via phone 587-233-4065 or email paige.knight@rsam.ca.
 
Not only will this new tax treatment reduce the tax burden on investors going forward, this process follows more closely to industry standard which we think ultimately makes things easier on investors and tax professionals.  
 
It’s important to recognize that under this same tax approach, it’s not unreasonable to have a year where the funds are up substantially and the capital gains bill would be relatively small. 
 
As a result of this larger than normal distribution, you will see a significant drop in the NAV/unit of our funds.  This is not a fund performance issue but a function of the distribution.  For tracking purposes, the starting NAV values for class A units for 2017 are $9.2953 for the Investment Fund and $8.8853 for the Opportunities Fund.  
 
The purpose of this letter was to notify you that we are working on your behalf to make positive changes, but I am personally not a tax professional, so please seek independent tax advice should you need it – much like we did. 

Please see Julian’s comments on January performance below.

Sincerely,

Jai Hawker

Capital Investment Fund

RSIF units increased 0.3% for the month of September and decreased -1.0% for Q3 of 2017.  Trailing annual volatility for the Investment Fund was 1.9% and its correlation to the S&P/TSX Composite Index was 0.34.  The Investment Fund has had positive performance in 72% of the months since inception and has outperformed the S&P/TSX Composite in 89% of the months in which the index was down.


The Investment Fund made 14 structured product arbitrage and 4 relative value arbitrage investments in the quarter.  The Fund’s volatility arbitrage strategy was active, with positive signals in each month of the quarter.  While not every volatility trade is profitable, we expect over time the strategy will produce positive returns given the historical premium of expected volatility over realized volatility.  At the end of Q2, we were monitoring 113 redeemable structured products with total market value of $8.6bn ($76mm average size).  The Investment Fund ended the quarter with 26 structured product investments.


Gross exposure (long + shorts) of RSIF was 162% (61% long and -101% short) as at quarter end.  Approximately 32% of the portfolio was invested in the structured products arbitrage strategy, 30% in volatility arbitrage, 22% in the multifactor strategy and 16% in relative value arbitrage.  

The relative value portfolio was flat in Q3 while the structured products, multifactor and volatility strategies declined -0.2%, -0.4% and -0.2%, respectively. 
 

Opportunities Fund

RSOF units increased 2.5% for the month of September and 3.6% for Q3 of 2017.  Trailing annual volatility for the Opportunities Fund was 6.5% and its correlation to the S&P/TSX Composite Index was 0.38.  The Opportunities Fund has had positive performance in 68% of the months since inception and has outperformed the S&P/TSX Composite in 96% of the months in which the index was down.


The Opportunities Fund made 10 new investments during the quarter, including 9 merger arbitrage and 1 relative value arbitrage investments, while exiting 15 investments.  At the end of the quarter, we were monitoring 105 risk arbitrage situations globally with total market value of over $762 billion.


Gross exposure (long + shorts) of RSOF was 170% (146% long and -24% short) as at quarter end with 54% of the portfolio invested in Canada.

The merger portfolio accounted for much of the Fund’s performance in Q3, gaining 2%, boosted by overbids for both Polaris Materials and Dimension Therapeutics.  The relative value and liquidation strategies added 1.3% and 0.5%, respectively.  The special situations portfolio declined -0.2%, with gains in securities offset by the weak US Dollar.
 

Outlook

One significant theme in the merger arbitrage strategy has been the voracious appetite of Chinese companies buying North American businesses in recent years.  This trend was partly driven by the desire of Chinese companies to withdraw their money from the country in front of potential currency devaluation.  This flood of capital out of the country, largely supporting foreign acquisitions, peaked in Q2 of 2016 at over US$150bn.  After large capital flows out of the country, the Chinese government clamped down and flows went positive in Q1 2017, the first time since 2014.  This indicates that Chinese bidders will have less of an effect on the Canadian and US merger arbitrage sector on a go-forward basis.

What’s also notable is the dramatic change in the Government’s acceptance of Chinese investment.  Canada’s policy on Chinese investment has done a 180 degree turn under the Trudeau administration.  The Trudeau government easily approved the Chinese acquisition of Canadian satellite technology firm Norsat International this summer.  The Liberal government also reversed the Harper-era decision to block a Chinese company’s acquisition of a Montreal high-tech firm.  Clearly, the current Canadian government welcomes Chinese investment with open arms.  This has the effect of de-risking a potential regulatory block of a China-led acquisition in Canada and we now assign higher probabilities of these types of transactions successfully closing.

This is in direct contrast to the absolute shut-down of Chinese investment south of the border.  The American foreign investment guard dog – the Committee on Foreign Investment in the United States (CFIUS), has become increasingly hostile to Chinese investment, either through endless delays or the outright blocking of acquisitions of American firms.  President Trump’s anti-China policy should not be taken lightly.  We have avoided all Chinese-led M&A of US-based firms, and will continue to do so for the foreseeable future. 

On October 5th, the VIX closed at an all-time low of 9.19.  To say that market volatility has been subdued recently would be an understatement.  This lack of volatility has presented headwinds for the Funds, as heightened volatility typically creates profitable investment opportunities in some of our arbitrage strategies.

Despite the unprecedented level of low market volatility, we continue to find attractive risk-reward opportunities in underfollowed and inefficiently priced securities; opportunities typically created by corporate actions.  We continue to search incessantly to unearth these uncorrelated, absolute-return investments in order to assemble portfolios with attractive risk-reward characteristics. 

We remain concerned regarding certain areas of froth in global markets.  European junk bonds currently yield less than the 10-year US Treasury, which makes no economic sense (no doubt caused in part by the ECB’s QE program).  The Bank of Japan owns 60% of all Japanese ETFs outstanding.  It’s difficult to consider these to be free markets when there is an unrelenting central bank bid for assets.  Equity market valuations are high as well, with both the S&P/TSX Composite and S&P 500 indices trading at over 20x earnings. 

Despite high valuations, the media has been prognosticating on a stock market bubble since at least 2010:

·         January 11, 2010: “US Stocks Surge Back Toward Bubble Territory” (Business Insider)

·         May 3, 2011: “Why This Stock Market Looks Like Tech Bubble 2000 All Over Again” (Business Insider)

·         March 27, 2012: “Robert Shiller Eyes Another Tech Bubble” (Yahoo! Finance)

·         December 2, 2013: “Nobel Prize winner warns of US stock market bubble” (CNBC)

·         May 6, 2014: “Time to Worry About Stock Market Bubbles” (New York Times)

·         September 13, 2015: “Fears grow over US stock market bubble” (Financial Times)

·         June 23, 2016: “Uh-oh. Is the stock market a bubble again?” (CNN Money)

·         September 12, 2017: “Hedge fund billionaire warns about stock market bubble” (CNN Money)

Meanwhile, global markets have surged, short selling hedge funds have shuttered and fundamental investors have lagged as the highest-valued firms have only continued to rise, leaving attractively priced securities in the dust.

Given our concern regarding elevated asset prices globally, it is notable that both RSOF and RSCIF have provided substantial downside protection in declining markets, outperforming the index in 96% and 89% of the months in which it declined, respectively.  It is when risk is perceived to be the lowest that risk management is the most necessary.

During this unprecedented period of rapidly rising asset prices, overly stimulative central banks and depressed volatility, a new asset class has emerged – cryptocurrency, led by bitcoin.  As you may know, Ross Smith has provided exposure to this emerging asset class through the Ross Smith Cryptocurrency Investment Fund, which was launched this past summer.  While risky and highly volatile assets, bitcoin and its alt-coin brethren have merit as they provide tremendous upside optionality to what many consider to be the greatest technological breakthrough since the invention of the internet – the blockchain.  As I write this, bitcoin has surged above US$5,000, a new all-time high. 

Julian Klymochko, CFA 

Trout Taylor