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CEO Insights

CEO Insights

Keeping it Real (as in “Real” Returns) (Q2-11)

Keeping it Real (as in “Real” Returns) (Q2-11)

Jun 30th, 2011

The following was excerpted from Third Eye Capital Management Inc.’s Q1 2011 Investor Letter.

Inflation is one of the biggest threats to an investor’s portfolio over time. It is also one of the most challenging risks to hedge because at best, any such hedge is imperfect and at worst, it fails to work. This challenge coupled with benign inflation statistics published over the last decade by governments in Canada and the U.S., means investors have likely become complacent about inflation. But the outlook for inflation is changing, and investors need to reconsider their asset allocations in order to maintain the purchasing power of the capital and returns of their portfolios.

There is a wide divergence of expert opinion on the outlook for inflation, even among policymakers. In Canada, the Bank of Canada expects prices and wage growth to be restrained by the strong loonie and sees both consumer and core inflation figures easing in the second half of this year. In the United States, the Kansas City Federal Reserve president voted against fellow members of the central bank by calling for tighter monetary policy to curtail future price inflation. For some economists, unprecedented money supply, mounting government deficits, and rising commodity prices are sure signals of a serious inflation problem on the horizon. Others believe there is ample slack in the economy evidenced by drops in industrial production and spikes in unemployment. Recent data from the OECD shows that developed economies are experiencing the lowest negative output gap since World War II. While the output gap is difficult to quantify, other measures of excess capacity such as capacity utilization and unemployment highlight continuing slack.

For investors, the inflation debate is more about timing. Most of the endowments, foundations, and pension plans we speak to do not perceive the threat as immediate but believe price pressures are forming in certain economies and that the secondary inflation effects of rising commodity prices has the potential to surprise on the upside. Asset-allocation decisions are increasingly taking inflation expectations into consideration, and investors are probing for insights on how to maintain the purchasing power of their assets over time and achieve real returns consistent with their investment objectives.

Conventional wisdom says that equities, real estate, and commodities are the most effective hedges against inflation. Bonds, and other debt instruments, according to the traditional view, are the worst because, in a rising inflation environment, fixed coupons and principal repayments are received with funds that have less purchasing power. But theory does not always match reality.

Equities represent a claim on dividend streams of corporate assets that are supposed to be able to pass on inflation in the form of higher prices. Inflation, however, can cause volatile earnings depending on the price elasticity of demand for a company’s products, and increase the risk-premium required by investors. Under these circumstances, equities may have a negative correlation to rising inflation. Take the experience of the 1970s, when inflation rose but most equity markets suffered negative real returns.

Real estate can be valued in a similar manner to equities and bonds, by discounting the expected future stream of cash flows by a required rate of return. These cash flows, in the form of rents and sale values, tend to move in line with inflation. However, a research paper published in the Journal of Real Estate Finance by Joseph Gyourko and Peter Linneman, entitled “Owner-Occupied Homes, Income Producing Real Estate, and REIT as Inflation Hedges”, concluded that real estate in its securitized form (i.e, REIT) exhibits the same negative relationship found with equities. The effectiveness of purchasing private real estate as an inflation hedge is also dubious if excessive leverage is used and if the timing of purchase is wrong.

There has been a lot of analysis about the inflation-hedging properties of commodities, and research does provide strong evidence that, at least in the short-term, commodities do provide effective inflation protection. In April 2009, the IMF sponsored a study that found, over the long-term, the effects of inflation caused commodity prices to fall gradually over time. The reasons were best described by Professor Jeffrey Frankel at Harvard University, who argued that higher real interest rates in response to an inflation shock caused commodity prices to fall due to three main factors: by increasing the discount rate for future extraction and growth in current supply; by raising the carry cost of inventories; and by encouraging speculators to shift out of commodity contracts and into treasury bills.

All the empirical evidence seems to support the theoretical arguments that bonds are a poor inflation hedge. However, bonds are a heterogeneous asset class and certain offerings like private credit can be very effective at outperforming inflation. Private credit instruments are typically short-term, so are less susceptible to duration risk, and have floating rate structures that reduce reinvestment risks that can erode purchasing power. Equally important, private credit instruments are over-secured, usually by a factor of 2 to 1, by business assets with visible values, which means that debt outstanding in notional terms is actually secured by assets valued in real terms. In an inflationary environment, private credit intrinsically becomes less risky and more valuable at the same time. What other investment can make that claim?

Milton Friedman, the Nobel Prize winning economist, stated “inflation is always and everywhere a monetary phenomenon.” Given the massive liquidity injections and ultra loose monetary policies employed over the past few years, inflation hedging should be an important component of any investor’s investment policy. It is difficult for a long-term strategic asset allocation to protect a portfolio against unexpected inflation, especially using traditional asset classes. However, there is an opportunity to enhance inflation protection in any portfolio through the tactical use of private credit.



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Instructions for the following sections: Individuals please answer Part A of Sections I and II; Institutions please have an authorized person answer Part B of Sections I and II.

Section I - Accredited Investor Threshold Questions:

Part A - For Individuals:

1. I certify that I have an individual net worth, or my spouse and I have a combined net worth in excess of $1,000,000.

2. I certify that I am highly a sophisticated investor who routinely invests sums of $250,000 or more.

Part B - For Institutions:

1. The submitter certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company.

2. The submitter certifies that it is a charitable organization, corporation or partnership with assets exceeding $5 million, and that was not formed to invest the Fund.

3. The submitter certifies that it is a corporation, partnership or trust with assets of at least $5 million, that was not formed to invest in the Fund, and whose purchases are directed by a sophisticated person.

4. The undersigned certifies that all of its equity owners are “accredited investors” as defined in United States Securities and Exchange Commission Rule 501(a) and who can satisfy the higher criteria for the same set forth in Section I, Part A above.

Section II - Qualified Purchaser Questions:

Part A - For Individuals:

1. I certify that I own not less than $1,000,000 in securities investments.

Part B - For Institutions:

1. The undersigned certifies that it is a bank, insurance company, registered investment company, business development company, or small business investment company

2. The undersigned certifies that it is a "family owned company" (as defined below) that owns not less than $5,000,000 in securities investments. A "family owned company" is defined as a company that is owned directly or indirectly by or for two or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendents by birth or adoption, spouses of such persons, the estate of such persons, or foundations, charitable organizations, or trust established by or for the benefit of such persons

3. The undersigned certifies that it is a trust that was not formed to invest in the Fund, the trustee or decision-making authority of which, and every person contributing assets to the same, is a “Qualified Purchaser” under one of the other definitions of this Section

4. The undersigned certifies that it is a person acting for its own account or for the accounts of other Qualified Purchasers who in the aggregate own and invest on a discretionary basis at least $5,000,000 in securities investments.

Questionnaire Submission:

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If you have any questions, please contact Chris Vokes, VP of Investor Relations at Third Eye Capital:

T 416-601-2270 ext 242
E chris@thirdeyecapital.com