Norrep Market Neutral Income Fund - 2016 Mid Year Report

July 26, 2016

It was a challenging first half of 2016 as Norrep Market Neutral Income Fund returned -1.4%. The good news is that the Fund was up 2.7% over the last four months of the period as markets normalized and began rewarding companies for good results and positive momentum. While we are not happy with the semi-annual results, we remain steadfast in our belief that owning a market neutral fund is an important part of a truly diversified portfolio.

Before we dive deeper into what worked and what did not work in the Fund, we want to review expectations. While it has been a difficult start to the year, the Fund is only down 1.4%. To put that in perspective, the S&P/TSX has been down more than 1.4% in a day 11 times so far this year. While we do not believe that comparing ourselves to the S&P/TSX in the short term is appropriate, reality is that almost everyone does from Globefund to Morningstar to most clients. Since results are driven by a comparison of the returns of long and short stock positions, to say that the stock market does not matter is nonsensical. When you are investing in the underlying holdings of an asset class, the volatility, behaviour, and characteristics of that asset class matter. By eliminating net exposure to an asset class, the direction of the returns should not matter but how the underlying assets are reacting is certainly a factor. In other words, having no net exposure to equities does not mean that equity characteristics and market behaviour do not matter although it should mean that the general direction of the equity markets is not important.

Over the long term, our stated goal is to provide equity-like returns (6% - 8% per year) with less volatility so there is something behind a comparison. The way that a market neutral fund can provide equity-like returns is by outperforming in down markets rather than keeping up in bull markets. We have often stated that “assessing a market neutral strategy based solely on a comparison in up markets is akin to saying that you should not own an umbrella because it did not rain last week.” We only need to look back to last year to remember why you should own a market neutral strategy. We believe in the long-term results of this strategy and are comfortable with how we are positioned for future returns.

In order to fully understand the results, we need to break them down and see what we find. When digging into our results, two things stand out immediately. The Fund had two short positions taken out in the first half of 2016. The first one was RONA which was taken out at an unheard of 104% premium from the previous day’s close on February 3. Unfortunately, the Fund held a 3.2% weight at the time. RONA had been paired up with Canadian Tire and that trade had been quite successful prior to the takeover (up about 10%). In all my years in the business, I cannot remember any takeover at that premium (except maybe on a micro cap energy or mining company). Unfortunately, the RONA takeover cost the Fund 3.2%. The second takeover was BCE taking over Manitoba Telecom at a 22% premium over the previous day’s close. Manitoba Telecom was a 2.5% weight in the portfolio so it resulted in a 0.5% hit to the Fund.

One of the risks of short selling is the possibility of a takeover. In general, stocks that are struggling and that are not as efficient as their peers are the most likely targets. While most of these struggling companies continue to underperform, sometimes they are taken over by stronger companies with better management teams. We accept this as one of the downfalls of shorting, but remember that we hold 50 short positions, on average, and our short positions have been very successful as a whole. Since inception, the takeovers of short positions in the Fund have been of the Manitoba Telecom variety, in that they have cost the Fund about 0.5%.

The good news is that nothing seems to be broken. If we exclude the two takeovers that cost the Fund 3.7%, the Fund would have been up 2.3%, which is a little lower than our six month target of 3.0%. The other factor was the early year anomaly of weaker momentum companies outperforming stronger momentum companies. The vast majority of the portfolio performed as expected. The bad news is, of course, that you cannot exclude things that happen in a Fund, and as a result, it has been a disappointing start to the year. As stated above, takeovers happen and we have to accept them as part of running a portfolio with short positions. They are not one-time events, although we would argue that the magnitude of the RONA premium was extraordinary in nature.

Below is an in-depth review of the Fund as well as some insight as to how we are positioning the Fund going forward.

While overall performance is the most important, we are pleased that the Fund continues to provide positive returns, on average, in months where the market is up and in months where the market is down. In other words, we have been able to remain indifferent to market direction, which is the ultimate intent of a market neutral strategy. This is confirmed by the Fund Beta of -0.06 and the Fund correlation to the market of -0.09. Despite some increased early year volatility, our longer term volatility, as measured by standard deviation, remains low at 6.2%. In what is probably a more important volatility number, downside deviation, the Fund looks even better at only 2.9%. We would like to take this opportunity to remind our investors that the Fund does not have a negative correlation so it will not go up every time the market goes down. Historically, we tend to do better in down markets and we have definitely made up much of our relative performance versus the S&P/TSX in down markets but we have essentially no correlation which means that we could be up or down when the equity markets struggle. The Fund has protected investor assets, as shown by the fact that the Fund has outperformed the S&P/TSX in 25 of the 28 months in which the S&P/TSX is down (90% of the time) since inception.

Since inception, the Fund has managed to provide positive returns in 58% of the months. When the S&P/TSX is up, the Fund has provided positive returns 58% of the time with an average monthly return of 0.3%. When the S&P/TSX is down, the Fund has provided positive returns 58% of the time with an average monthly return of 0.8%. This does mean that the Fund has been down 42% of the months. However, providing positive returns in 58% of the months has led to very positive long-term results.

One final thought on performance. Below is a graph of the best and worst one year returns of different asset classes since the inception of Norrep Market Neutral Income Fund. While the Fund has not been completely bulletproof, we think that you would agree that from a risk/return point of view, it looks pretty good.

Analysis of 2016 Year-To-Date

On June 30, 2016, Norrep Market Neutral Income Fund held 47 long positions, totalling 101% of the portfolio, and 52 short positions totalling 101% of the portfolio with 0% net exposure to all ten S&P/TSX sectors. The Fund was 62% invested in exact sub-sector pairs and 39% invested in sector pairs. The long positions were 29% small cap, 40% mid cap and 32% large cap while the short positons were 28% small cap, 39% mid cap and 34% large cap.

Breaking down performance, let’s start by reviewing the bond portfolio. At the end of June, bonds made up 98.4% of the portfolio through 15 positions. As a whole, they currently have a yield to maturity of 3.4% and a modified duration of 2.4 years. All the bonds are considered investment grade, except an 8% weight in Norrep Short Term Income Fund (which includes some senior loans). The Fund also holds a combined 9% weight in two short-term investment grade bond ETFs for added liquidity. We estimate the return on the bond portfolio was 2.0% over the first six months of the year.

Our two best performing bonds in the first half of 2016 were a TransAlta bond maturing in 2019 which provided a total return of 3.8% and a 2018 Veresen bond which returned 3.3%. Our worst performing bond was a 2017 Reliance bond which returned 1.5%. In the first half of the year, Norrep Short Term Income Fund returned 2.6% and our two bond ETFs returned 0.4% and -0.2%. We have received a few questions about the performance of the bond portfolio over the last few months to the point where we believe we need to remind our investors of why we hold them. Simply put, the proceeds from the short equity positions are used to buy the long equity positions, which means we still have the initial investment left. We can choose to do nothing with that money and earn 0% or we can do what we are doing which is to invest that money in a short duration, investment grade bond portfolio that we will use to help cover the fees of the Fund.

Given that all the bonds are bought with the intention of holding them to maturity, what we continually monitor is whether we believe that the underlying investment grade company has a chance of going bankrupt before the maturity date from an equity point of view. Given that bonds are typically more secure than equity, if we believe that the company is a going concern from an equity standpoint, we are happy owning the bond. We know that our bonds will mature at par so if they get there a little faster then we expect, it just means that they will add more value in the future. In the first half of 2016, we sold two 2017 bonds (EnerCare and Brookfield Office) and replaced them with two 2019 bonds (Artis REIT and Canadian Natural Resources) and one 2018 bond (Veresen). We also had a Home Capital bond that we initially bought on the new issue mature in May.

In the first half of 2016 we had many successful trades and a few that did not work out as planned. In general, we attempt to close out trades that have not worked quickly and let the winners run by increasing their target weights. Having said that, we are very active in trading around core positions and will move quickly to reduce our target weight if a company’s reported numbers start to slow down or if their valuation gets excessive.

The exact (or sub-sector neutral) pair part of the portfolio tends to be less volatile as the stocks tend to be more correlated to each other. Our best sub-sector neutral pair trades that we closed out in the first six months of 2016 were long Andrew Peller / short Corby Spirit & Wine (+49%), long Metro / short Empire Company (+26%) and long Canadian Natural Resources / short EnCana (+26%). The best exact pairs that we continue to hold are long Peyto Exploration / short Prairie Sky Royalty (+28%), long Kirkland Lake Gold / short Goldcorp (+27%), and long Western Forest Products / short West Fraser Timber (+19%). Outside of the two takeover scenarios, the worst pairs that we closed out were long Keyera / short Pembina Pipeline (-25%) and long A&W Revenue Royalties / short MTY Food Group (-24%). The worst performing pairs that we continue to hold are long Clearwater Seafoods / short High Liner Foods (-18%), long Air Canada / short WestJet (-17%) and long Cominar REIT / short Riocan REIT (-8%).

The top performing long stocks that we sold in the first six months of 2016 were First National Financial (+47%), AGT Food and Ingredients (+24%), and Intertape Polymer (+26%). The top performing long names that we continue to hold are Choice Properties REIT (+23%) and Dollarama (+15%). The worst performing long positions that we sold were Labrador Iron Ore (-24%), Transcontinental (-19%), and DH Corp (-11%). The worst performing long stocks that we continue to hold are Alimentation Couche-Tard (-9%), Vecima Networks (-8%), and Gildan Activewear (-4%).

The top performing shorts that were closed out during the last half of the year were Redknee Solutions (+50%), HudBay Minerals (+33%), and SunOpta (+28%). The top short positons that we continue to hold are Methanex (+16%), Exco Technologies (+15%), and Solium Capital (+15%). The worst performing shorts that we covered were Ritchie Bros Auctioneers (-32%), Lundin Mining (-28%), and Maple Leaf Foods (-28%). The worst performing shorts that we continue to hold are Rogers Sugar (-32%), Yellow Pages (-20%), and Pure Technologies (-17%).

It is important to note that even the longs and shorts that are not exact pairs are still managed against each other to keep the overall net sector weights at zero. For example, one of the worst performing longs was Labrador Iron Ore (-24%) but it was managed against HudBay Minerals (+33%) so as a pair, this was a successful trade. All positions need to be looked at in the overall portfolio context rather than in isolation.

The sub-sector neutral or exact pair part of the Fund has not been very successful to start 2016. Outside of the two takeover pairs, it was not bad but still needs improvement. Over the first half of 2016, we have found that weaker stocks with worse momentum have performed better than stronger stocks with better momentum. By sector, the Fund was very successful when pairing up materials, energy, and consumer staples stocks, but not as successful in telecoms, consumer discretionary, industrials and financials.

Our sector neutral (non-exact pairs) were strong in the materials, financials, and technology sectors but not as successful in the industrials and consumer discretionary sectors.

Overall, the Fund provided positive returns in energy, materials, consumer staples, financials, technology, and utilities. It provided negative returns in industrials, consumer discretionary, and telecommunications.

We made a few changes to gross sector weightings in the first half of 2016. We continue to see irrational behaviour in the Energy space so we have kept our gross exposure low at 8.6% (net exposure of 0%) although that is a little higher than the end of 2015. In the Basic Materials sector, we increased our gross weight to 14.7% from 9.5%. On the flip side, we reduced our gross exposure to staples from 14.4% to 9.0% as we locked in profit and closed out trades.

Understanding Pair Trades

When discussing stocks or pairs, we understand that not everyone will see what we see or agree with our decisions so we thought it would be of interest to break down two of our pair trades; one that has worked to this point and one that has not.

We established our pair of long Western Forest Products / short West Fraser Timber in mid 2015. To date, this pair has been very successful, returning around 19%. On top of that, volatility in these stocks has allowed us to generate additional returns by trading around the core positions. Looking at the below characteristics, it is easy to see why we continue to hold this pair. Western Forest Products continues to trade at half the P/E multiple despite a better ROE, similar expected growth rates, lower downward estimate revisions, a higher yield, and lower debt.

Yield Cash Flow /
Long: Western Forest






Short: West Fraser Timber






A less popular trade might be our pair of long Air Canada and short WestJet. Most investors who do not look at the numbers and just go by the names would probably go the other way. For us, the numbers have just become too compelling to ignore. We also established this pair in mid 2015 and to-date, we are down about 17%. It started as a small 1% gross weight, but we have recently increased our gross weight to 2.5%. If you suspend your beliefs about Air Canada (or airlines in general, given that this is a pair and therefore most of the factors that impact the airline industry are offset), the numbers are quite compelling. Air Canada trades at about one third the valuation level on a trailing basis and almost one quarter the valuation level based on 2016 expectations. That is despite better expected growth (or, in this case, less negative growth) and the fact that Air Canada posted an excellent, significantly better than expected quarter last time around versus a poor WestJet number. To top it all off, the ability to service debt levels is not as far apart as one would think.

Cash Flow /
Long: Air Canada





Short: WestJet







Expectations for the rest of 2016

Going forward, we will stick to the methodology that has worked since the Fund’s inception. We will not chase returns through sector exposure nor through a long bias. We will continue to exact pair as many trades as we can and rebalance the Fund on a daily basis to ensure there is no market or sector exposure. The Fund remains well diversified as it has holdings in nine sectors but no net exposure to any one sector. We will not take on the added risk of having sector exposure, nor will we concentrate the portfolio into a few sectors.

We do not expect to make any changes to the way we are managing the Fund. On the equity side, we continue to break the Fund down into two segments. The “exact pair trade” segment (about 60% of the portfolio) is where we match a long and a short position of two stocks in the same sub-sector and manage them against each other. This segment should be unaffected by economic and industry news. The goal here is to ensure that the long position outperforms the short position regardless of whether they are up or down. Remember that each pair is brought back to dollar neutral at the end of every day. The second segment is the “sector neutral pair” (about 40% of the portfolio) where we match a long and a short in the same sector but not the same sub-sector. For example, we may be long a technology software stock and short a technology hardware stock. This segment may not be immune to economic or industry data but it should be sheltered from much of it. Again, we attempt to eliminate equity exposure on a daily basis by having net zero dollars invested. Below is a chart of the characteristics of the long and short positions as well as the S&P/TSX.

  Long Positions S&P/TSX Short Positions
Trailing P/E 13.6x 18.6x 21.2x
Expected P/E 13.3x 18.7x 19.5x
Trailing ROE 16.2% 12.0% 7.3%
Earnings Surprise 2.1% -0.2% -0.7%
Estimate Revisions 2.5% -2.5% -5.9%
Quarterly Earnings Momentum 2.5% -4.5% -4.1%
Yield 3.2% 3.0% 3.3%


Why Own a Market Neutral Fund

Calendar 2015 was a great reminder of why it is important to own a market neutral strategy to properly diversify a portfolio. It was the second year since our inception five years ago in which the S&P/TSX posted negative returns and yet the market neutral strategy has able to post a positive number both times. Market neutral funds are not owned to enhance returns in strong bull stock markets; they are there to be a friend in the inevitable down markets whilst still providing reasonable returns in up markets. One of the best ways to make money in the long run is to lose less during market downturns. Returns do not generally come from one big year they come from consistent, positive returns in many years. The best part about that is that it decreases portfolio volatility. Market neutral funds are long-term, full market cycle strategies that should be looked at in an overall portfolio context. They are there to increase portfolio diversification and reduce overall portfolio volatility over a full market cycle. In other words, market neutral strategies show their true worth to your portfolio during market pull backs so do not abandon the strategy when times are good as you will likely regret that decision when things go south. Owning something with the potential to go up when everything else is down is an excellent way to manage overall portfolio risk.


Our objective from the beginning was to provide equity-like returns with bond-like volatility over a full market cycle. More specifically, our goal was, and still is, to provide 6% - 8% return per year with less volatility than the market over reasonable time periods. From our presentations, the four stated reasons to own the Fund are to provide absolute returns uncorrelated to the stock market, offer lower volatility than the stock market, provide downside protection, and distribute quarterly income. We have been able to deliver on all four “reasons to own”. A short-term downward move is something we need to overcome but nothing that makes us worried as to the long-term objectives.

Thank you for your continued support.

  6 month 1 year 3 year* 5 year* Inception*
Norrep Market Neutral Income Fund – F series -1.4% -0.1% 2.2% 5.8% 5.9%
S&P/TSX TRI 9.8% -0.2% 8.3% 4.2% 3.8%
FTSE TMX Universe Bond Index 4.0% 5.2% 5.6% 5.2% 5.1%
FTSE TMX Short Term Bond Index 1.1% 1.6% 2.7% 2.7% 2.7%

* Annualized   As at June 30, 2016

​Reviewing Norrep Market Neutral Income Fund and its style

If we receive $1 million of purchases in Norrep Market Neutral Income Fund, we start by buying $1 million of investment grade, short duration bonds that we plan to hold to maturity. The intent of this part of the portfolio is to cover all the fees; not enhance the returns. We then pair up $500,000 to $600,000 in long and short pairs of stocks that are in the same sub-sector. We trade these pairs against each other so that if the long does better than the short, then the portfolio profits. Finally, we short $400,000 to $500,000 of stocks and use the proceeds to pair them with long positions of stocks in the same sector (but not the same sub-sector). We rebalance these positions on a daily basis to make sure that the Fund never has any market exposure. We also pay an approximate 4% annual distribution (1% per quarter) to give investors some tax-efficient income (historically, it has been more than a 50% capital gains distribution).

At all times, Norrep Market Neutral Income Fund has 0% net equity exposure. By having 0% net equity exposure, our performance is not determined by the direction of the market or even if our stocks go up or down; it is determined by a comparison of our long positions and whether they outperform our short positions. If our longs go up more or down less than our shorts, the Fund will deliver a positive return. As a comparison, a typical equity mutual fund has approximately 100% net equity exposure which generally means that when the stock market is up, the fund is up and when the stock market is down, the fund is down. Note that if we always provide positive returns when the market is down, we would have a negative correlation; not zero correlation. If we had a negative correlation; the Fund would likely be down whenever the market is up, which is not what a market neutral fund does. Instead, we have no correlation to the market and thus market direction does not matter.

We manage the long side of the portfolio by looking at the universe of stocks with strong momentum characteristics and then choose the stocks with the best valuations. On the short side, we compile a list of weak momentum companies and then choose the stocks that we believe to be overvalued. We are careful to short expensive stocks on a P/E basis over “story” stocks (that have no P/E). Note that momentum does not necessarily mean growth, although that is one of the factors. Momentum includes growth, earnings surprise, estimate revisions, and price momentum.

This is a long-term investment product that cannot be evaluated on one or two month’s performance, as we have the same probability of providing positive returns in up markets as in down markets. We believe that, in general, stocks go up and down for a reason that may be country-related, industry-related, economy-related, or company-related. In our market neutral fund, we do our best to eliminate the first three and focus on company specific issues. For example, we examine attributes such as valuations (are they too high or too low?), profitability, trailing and expected growth rates. How are companies doing versus consensus expectations? Are those expectations changing? Is their dividend safe? Are their debt levels too high? Our investment decisions are based on how stocks tend to react and where we believe their fair value is, given the answers to the above questions. We also look for catalysts or upcoming events that may trigger a re-valuation to more appropriate levels.

One last reminder, just because we establish a pair trade today, it does not mean that the market wakes up tomorrow and corrects that inefficiency. It can sometimes take a year or longer before the market gets it right.

For More Information:

Keith LesliePortfolio Manager

He has over 20 years of investment management experience. Prior to joining NCM in 2001, Keith worked as a Quantitative Analyst at a western Canadian investment firm. Keith brings a different perspective to the firm’s investment process, using statistical techniques, valuations…

Notice to Reader:

Unless otherwise stated, opinions expressed in this document are those of the author and are not endorsed by the author’s employer. No guarantee, either express or implied, is made that the information in this document is accurate, complete or up-to-date. The contents of this document are for informational purposes only and are not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.