Bond Market Storm Warning

By Richard N. Croft, CEO CIO
Croft Financial Group

Investors are constantly trying to decipher the cause and effect of macro events. Investors must ask whether the production cuts OPEC at their meeting last week will have a meaningful impact on the supply glut that exists in the energy space. Does the modern-day OPEC even matter? How one rates those issues will be reflected in an investment decision to buy or sell energy or transportation stocks.

Early this month we witnessed firsthand the impact macro events can have on the global landscape. A Saturday evening dinner between President Trump and Chinese Premier Xi at the G-20 summit set the stage for an easing of trade tensions between the world’s two largest economies. Global markets reacted positively on Monday but quickly retreated on Tuesday as Trump’s Twitter finger rehashed the “trade deal” as he saw it. Apparently, he was the only visionary to see it!

Certainly “Trump’s Art of the Deal” negotiating strategy was partly to blame for the ensuing 800-point sell-off on the Dow Industrial Average.

But there may have been more to the sell-off than can be explained by Trump’s vitriol.

There has been growing anxiety around points on the US yield curve that have inverted. Some analysts think that may be indicating an economic slowdown which could be exasperated by rising interest rates. In my view the bond market will drive global equity values over the next two quarters and overshadow other macro events related to trade and GDP growth.

What spooked the market is the inversion that occurred at junctures of the US treasury yield curve. Notable at the close of trading on Tuesday, was the inversion between five-year treasury notes (yielding 2.79%) and three-year notes yielding 2.80%. (see figure 1)

Yield curveSource:

Miniscule blips may not seem noteworthy, but traders fear that the three/five inversion may be a precursor of further disruptions along the curve. The worst-case scenario would see an inversion across the entire yield curve (i.e. long-term bonds yielding less than short term notes and treasury bills) which is seen as an early indicator of recession.

Mind you it wasn’t just the three/five inversion that caught the attention of analysts. There was a dramatic – at least for the bond market – slippage in the rate differential between ten-year treasury bonds (yielding 2.91%) and two-year treasury notes at 2.80%. The differential slipped 6 basis points (.06%) in one day, which for bond traders is akin to a 500-point decline in the Dow Jones Industrial Average.

If the yield differential between two and ten year treasuries should flip (i.e. become inverted), that would signal a recession. It could happen! The differential between two- and ten-year treasuries is now 11 basis points (0.11%) which has not been seen since 2007 just before they flipped. We all know what followed!

The two/ten differential is relevant because it has such a major impact on the banking sector. Banks borrow short term (maturities less than two years) and loan long term (maturities ten years and longer). Typically, the largest segment in a US bank’s loan portfolio is 30-year fixed rate mortgages. In that environment, an inverted yield curve has a major impact on margins for US financial institutions.

So, what are we to make of these events? Are they a dire warning of an impending slowdown in growth, perhaps even a recession? Or are these simply dislocations caused by some unusual behavior? One could make a case for either scenario but what’s important is how the US Federal Reserve (FED) reads the tea leaves.

Understanding the Yield Curve

Before getting to the cause and effect of yield curve inversions, we need to understand the minutiae of the yield curve. Effectively the yield curve is a line that plots interest rates at a point in time for bonds having equal credit quality but differing maturity dates.

According to Investopedia, “The most frequently reported yield curve compares the three-month, two-year, five-year, 10-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is used to predict changes in economic output and growth.”

Investopedia goes on to say; “the shape of the yield curve gives an idea of future interest rate changes and economic activity. There are three main types of yield curve shapes: normal, inverted and flat (or humped).”

A normal yield curve slopes upward from left to right reflecting higher yields as the term to maturity rises. That’s considered normal because the longer the time to maturity the more potential disruption in the value of the bond. Traders measure the risk associated with time using a concept known as “duration”.

Duration measures how many years it will take for you to be repaid the total cost of the bond through the cash flow from the bond. Say you purchase a bond at $100 and the bond pays you $5.00 per year in interest. It would take twenty years at $5.00 per year to recover the cost of the bond. The bond’s duration would be 20 years.

That’s important because duration leads to another measure referred to as “modified duration” which calculates the present value of the bonds cash flows in years. Without going through the calculation, suffice it to say that the modified duration for our hypothetical 20-year duration bond would be about 12 years… give or take.

Modified duration is used to calculate the bond’s sensitivity to changes in interest rates. Using our modified duration example of 12 years, we would expect the bond to fall 12% for every 1% rise in interest rates and vice versa. It is because of this risk factor that investors typically demand a higher yield for longer duration bonds which is reflected in a normal yield curve.

A flat yield curve, which is the closest observation to the current environment, typically occurs when the economy is transitioning from expansion to slower development and even recession. The yield on shorter term bonds rise as central banks tighten the money supply to tamp down inflation expectations.

Longer term yields tend to contract as portfolio managers shift allocations away from more volatile equities into fixed income assets. That causes bond prices to rise (and longer-term rates to fall) as equity values decline. The potential end game is the inverted yield curve where longer term maturities trade at lower yields than shorter maturities in anticipation of a major economic slowdown and even a recession

 Headwinds or Tailwinds

Returning to the main question; what is the yield curve telling us? There is a school of thought that the current dislocations along the yield curve may simply be the result of market forces.

Fact is, we are in a unique situation where the FED is raising rates while reducing their bloated balance sheet from three rounds of quantitative easing after the financial crisis. In other words, the FED is selling massive amounts of bonds in the two to seven-year maturity spectrum which may be the cause of lower values for those maturities. Lower bond prices result in higher yields which may be distorting the curve within that spectrum.

We are also seeing massive bond purchases from the European Union particularly from Germany where short term rates remain in negative territory.(see figure 2).

german ycSource:

Depending on what maturity you are looking at, German rates are 225 to 340 basis points (see figure 3) lower than US rates. The point is, European investors can buy lower risk US bonds and receive a higher return for doing so. They also benefit from a stronger US dollar which for the last year, has been rising against most world currencies.


The European Central Bank (ECB) is also planning to exit their quantitative easing at the end of 2018, which presumably, means that the ECB will begin to unwind their balance sheet likely resulting in similar dislocations along the EU yield curve.

If this is the cause of dislocations along the yield curve, then it may not be predicting a recession but simply be the market’s reaction to unusual activity. Even if it is not the case, one can take solace that the yield curve’s notoriety as a leading recession indicator is not grounded in fact. As many analysts contend; the yield curve has correctly predicted twelve of the last five recessions.

Action Plan

So how should investors manage through the current environment? What we know is that the information provided in this article is the same information being used by a data dependent FED to set interest rate policy.

I suspect the flat yield curve is front and center as a risk factor. Raising rates at the short end of the curve while selling bonds in the middle of the curve may spook the market into a recession. A falling stock market impacts wealth and ultimately consumer spending patterns. If consumers tighten their wallets that could trigger a slowdown which could ultimately lead to a recession.

Initially it was thought the FED would raise rates in December and four more times next year. However, the notes from the most recent open market committee meeting were not as hawkish and implied that the FED was not on a pre-destined course for rate hikes.

In my view – and there are many conflicting opinions – there is a 50% chance that the FED raises rates in December and I suspect we will only see two hikes over the next twelve months (including a December hike if it occurs).

In that scenario I suspect global equity markets will continue to wobble which means investors should look to hedge out some of the risk. Covered call strategies that we have talked about in previous editions should provide some protection over the next two quarters.

You might also think about reducing your equity risk by purchasing value stocks with solid dividends. The dividends should provide a floor which should support blue chip well-capitalized companies.

The Rise of the Machines

By Richard N. Croft, CEO, CIO

You have probably heard a lot about artificial intelligence or “A.I.” if you have tech savvy friends. There was news this week that Canada was bidding on a new A.I. space arm for the unmanned moon orbiter that the U.S. is planning to launch in the next few years. The space arm needs to be able to learn simple tasks so that ground personnel can manage the orbiter by telling it to execute this or that rather than manipulating the arm through a complex series of movements. The IBM Watson project is another A.I. example where learning software tools optimize data collection and dissemination.

I raise this issue because A.I. software is driving many of the investment decisions for Wall Street hedge funds. A.I. software digests new information and makes trading decisions based on sophisticated algorithms. The problem is that it can have a major impact on your portfolio and the fallout can occur in a matter of minutes.

We have seen this play out over the past couple of weeks. Notable was the activity on Oct. 10 when the Dow Jones Industrial Average fell 800 points in one day. Much of the move occurred in the afternoon, when stocks appeared to fall off a cliff.

As expected, there was “insightful” spin on financial networks advancing reasonable cause and effect explanations. Market rotation was at the top of the list as analysts opined that managers were shifting focus from momentum (i.e. FANG) to value stocks (i.e. banks and utilities). Economists also weighed in, citing higher interest rates, trade tensions causing a sharp sell-off in Chinese markets, and more recently, concerns around the Italian budget deficit.

These are all reasonable arguments that, longer-term, will influence market trends. But the sell-off on Oct. 10 was more about A.I. then with any single motivating factor. You could see it during the day. Trades were triggered when the yield on the US ten-year Treasury note crossed 3.25%. There was a clear rotation away from FANG stocks (Facebook Amazon, Netflix and Alphabet (i.e. Google) and small caps with high debt to equity ratios into banks that benefit from higher rates.

The quick and sharp sell-off caused widespread angst, which carried over into virtually all sectors. At one point there were ten stocks down for every one that was up. For some perspective, the March 2009 post financial crisis bottom occurred at a point when there was a nine to one ratio of down to up stocks.

What makes me believe this was based on an algorithm was the fact that despite the Oct. 10 across the board sell-off we did not see significant capital movement away from stocks as an asset class into bonds and gold. To that point, I draw your attention to the accompanying chart showing the Dow Jones Industrial Average (the black bars) relative to the TLT (20-year Treasury bond ETF) and GLD (Gold bullion ETF). Notice when the Dow fell 800 points on Oct. 10, TLT and GLD barely moved. As the Dow fell another 400 points on Oct. 11, TLT moved higher by 0.8% and GLD was up about 2.5%. TLT and GLD have for the most part, remained at Oct. 11 levels.

I suspect the reaction on Oct. 11 was caused by the follow through in price action on the Dow. Investors were taking Wednesday’s move more seriously and wanted to shift some assets into safer havens. We saw a rebound on Friday, October 12, which, based on the action this week, seems to have been a bear market bounce.


This preamble sets the stage for the importance of staying focused through market turmoil. A.I. has simply shortened the time line of seismic shifts. It used to take weeks for traders to transition from bullish to bearish. It now happens in days and hours.

I’m not a big fan of money management via algorithms. It is not new and previous iterations have not benefitted investors. For example, the 1987 stock market crash was exacerbated by program trading, where algorithms systematically raised cash when specific price points were breeched. As the market fell through pre-determined levels, selling picked up. That caused further downside movement. The speed of the October 1987 sell-off caused wide spread panic and in the end did not protect investors in the way it was originally intended. Program trading went down as a failure and was pushed to the sidelines through much of the 1990s.

But in Wall Street, what goes around comes around. As a result, algorithms now account for as much as 30% of the trading activity on any given day. And this at a time when there are fewer shares to trade because of significant stock buybacks and institutional investors who follow a buy and hold approach (think Warren Buffett).

Make no mistake. NYSE and NASDAQ market makers who are charged with providing liquidity are keenly aware when they are taking the other side of a trade triggered by an algorithm. They also know that a machine is acting on electronic impulses and market makers will take advantage of that by shifting the bid and ask prices in accordance with the direction being taken by the algorithm. For the rest of us, that creates a trading pattern where we get sporadic volatility spikes interspersed with longer periods of narrow price swings.

It is virtually impossible to trade within these variables. I only hope that by understanding what is happening behind the scenes provides some comfort that will allow you to stick with an investment plan through turbulent times.

Longer term focus

If you believe, as I do, that intraday gyrations are more noise than substance, then you can focus on the factors that have real long-term implications. If institutional investors are shifting strategies from momentum to value, banks should benefit and FANG stocks should weaken.

It’s the same with the interest rate scenario. Higher rates should benefit banks, insurance companies, and large cap tech companies with sizeable cash hordes. Higher rates will be detrimental to small cap stocks because borrowing costs will rise. They will be particularly harmful to companies with significant leverage. I’m not sure that the current rate environment will have any major repercussions, but clearly the 3.25% rate on U.S. ten-year Treasury Notes is the current demarcation line.

But here’s the rub! Suppose we are correct about what is driving investment decisions. The point of our A.I. preamble is that much of what we think will happen has probably been priced into the market. The reaction time is simply too short to make moves after the fact, which means it is better to hedge your risks with a portfolio that can function within a multitude of detrimental scenarios.

Bottom line: Build an all-weather portfolio within your risk profile. Trying to trade the current environment will harm your pocketbook.


U.S. Economy Still Chugging Along

The economy South of the border continued to look positive during the month of August and now into the better part of September. This is despite continued political drama. Jobless claims are down, and job creation is up along with consumer confidence.

The GDP (Gross Domestic Product) numbers for the U.S. also came in strong.  An economy is considered to be in a recession or economic slow down after 2 quarters of declining GDP.  Strong numbers are a positive sign that the U.S. economy is still chugging along.

Investors demonstrated their confidence by pushing S&P 500 to all time highs, breaking the record as the longest running bull market in history.

A point that is not lost on our management team as Croft Portfolio Managers continue to cautiously take advantage of the trend.

Canadian equities had a tough August as trade concerns between the U.S. and China impacted the materials sector, while the overturn of the Trans Mountain Oil Pipeline expansion weighed heavy on energy.

Oil as a commodity finished the month of August about where it started after some volatile swings and currently remains with in the 67 to 69 range.

Gold hit a recent low of $1170.00 but rallied quickly to settle back above $1200.00. This trading behavior continues to be heavily influenced by the swings we have seen in the U.S. Dollar as of late.

Fund Performance

TCG 531 Equity Growth Fund

In August, the Equity Growth fund finished positive 3.27% while its benchmark, TSX Total Return Index was negative 0.82% for the month.

Year to date, the Equity Growth fund is up 8.32% with the TSX TR benchmark trailing at 2.27%

With Canadian banks reporting at the end of August, and given expectations for interest rate increases, the Canadian Financials index approached a six-month peak near the end of August.  The Investment Review Committee took the opportunity to re-evaluate the Canadian bank holdings and decided to close out a position in National Bank of Canada (NA.TO).  Although this company had performed well in the past, according to lead manager Alex Brandolini, research confirmed that earnings quality has been weak, and the upside on the financial stocks is limited.  Given that view, we decided there would be better places to deploy the capital.

Over the month of August, the momentum factor continued to provide opportunities in Canada and the United States.  Canada Goose Holdings Inc (GOOS.TO), a Canadian Consumer Discretionary stock, was added to the portfolio during the mini-momentum correction.  This company exhibits super-normal growth and has a history of beating expectations, but also doesn’t trade on a lot of volume.  When a significant holder of shares in a company that trades on low volume chooses to exit the position, it often creates large moves to the downside and an opportunity to get in at a more favorable price.  Given the fundamentals of the company, its factor exposures and future prospects, we took the opportunity to buy the company on a pullback.

TCG 534 Income Fund

Our Income fund finished the month of August up 2.27% compared to the Real World Index Income benchmark, which was up 0.39%.  Year to date, the fund shows gains of 6.20% compared to its benchmark, which trails at 1.28% for the year so far.

Lead manager Mark McAdam suggests that the strong returns in the fund can be attributed to the acquisition of Enercare (ECI) by Brookfield Infrastructure Partners for a 52% premium. We’ve also seen strong, active trading returns on Constellation Brands Inc. (STZ).

Overall, the fund continues to overweight the Technology sector while reducing exposure to the Consumer Discretionary sector.

In addition, some exposure to the Telecommunication sector was introduced. According to Mark’s analysis, valuations in this sector are attractive and many companies feature high dividend yields.

Equity exposure has also been reduced in an effort to lower the risk of the Pool, and put options on the S&P 500 remain in place as part of our ongoing hedging strategy.

TCG 539 Option Writing Fund

Our Option Writing Fund is designed to drive cash flow using income generating option strategies regardless of market direction.

The fund finished August positive with a 2.26% gain, beating its benchmark, the Montreal Exchange Covered Call Writers index, which finished the month positive 0.30%.

Year to date, the fund sits positive at 4.44% compared to its benchmark, which trails slightly at 3.60%.

Lead manager Richard Croft confirms that as highlighted last month implied volatility remains at short-term lows and continued to contract in the month of August. This continued contraction has reduced the premiums collected from our option writing strategies. In response, Richard has continued to shorten the terms to expiry of these options, with a current average term to expiration of 26 days. The objective of writing option contracts with shorter terms until expiration is to benefit from the accelerated time value erosion characteristic of these options.

Richard continues to maintain a balance between Value and Momentum stocks. The fund currently has a 48% exposure to value stocks, 36% exposure to momentum stocks and 16% cash.

The current exposure to the U.S. Dollar is approximately 35% which Richard notes, depending on the outcome of the NAFTA negotiations, could be volatile relative to the Canadian Dollar over the short term.

 Current Outlook and Expectations

The length of the current bull market, now officially the longest on record for U.S. equities, concerns some investors.  According to Investment Review Committee consensus, what’s different about the new high on the S&P 500 achieved in August, relative to the peak we saw in late January is that valuation multiples look much better this time around.

Much of the volatility over the last month was sparked by risks within Emerging Markets.  Historically, weakness in Emerging Market stocks has not spilled over into U.S. markets without a significant surge in the U.S. dollar and a significant drop in oil prices.  While the U.S. dollar has strengthened this year and the price of oil has come off its peak, neither are anywhere close to the magnitude associated with previous U.S. market downturns.

To summarize, economic fundamentals continue to support a positive view on the markets.  Both macroeconomic models and bottom up forecasts, which focus on company fundamentals, indicate this bull market continues to have legs to run.

That said, although we plan to continue to be fully invested while the overall outlook remains positive, we will continue to re-evaluate and adjust as market conditions change.

R N Croft Financial Group

August 2018 – Momentum Meltdown

One of the most notable headlines for the month of July was the significant sell-off in 2 of the FAANG stocks. FAANG is an acronym used to describe the tech stocks which have been leading the market for quite some time. The group includes Facebook, Apple, Amazon, Netflix and Google.

These stocks have been very attractive to investors due to their upside momentum, however both Facebook and Netflix surprised the market with less than favorable guidance during their latest earnings report, sparking a momentum factor meltdown.

On the Canadian front, financials remained strong while materials (most notably gold) continued to sell off along side energy.

Fund Performance

TCG 531 Equity Growth Fund

For the month of July, the Equity Growth fund finished positive 0.68% while its benchmark, the TSX Total Return Index added 1.15%

Year to date, the Equity Growth fund is up 4.89% with the TSX TR benchmark trailing at 3.12%.

Lead manager Alex Brandolini confirms that broad performance within the Equity Pool was strong for the month of July except for Facebook and Netflix. Facebook detracted from pool results significantly at the end of the month leading to a drag in performance.

On July 25th, Facebook reported a beat on Earnings Per Share (EPS), but a miss on both revenue and average monthly users.  Further, CEO Mark Zuckerberg provided an outlook for operating margins
that disappointed investors.

On the back of these disappointing results, Facebook registered the largest one-day drop in market capitalization in history.

We feel concerns about margin compression are overblown since we believe Mark Zuckerberg and COO, Sheryl Sanderberg, along with their industry leading experience, will find ways to monetize content consumption.  Further, we believe there is a certain amount of conservativism built in to the guidance provided by Zuckerberg so he can return to a “beat and raise” cycle following this revenue miss.

Notable actions taken within the Equity Pool included selling Boyd Group Income Fund as it reached full valuation.  This was part of our ongoing strategy of actively managing and locking in profits on our momentum stocks. We purchased a couple of Canadian Momentum names with strong fundamentals on a pullback.  Strategic option writing also continues to be an active strategy to take advantage of highs and lows on some of the technology stocks on our watch list, as prices continues to chop about.

 TCG 534 Income Fund

Our Income fund finished the month of July up 1.20% compared to the Real-World Index Income benchmark which was down 0.15%. Year to date the fund sits positive at 3.84% compared to its benchmark which trails at 0.89%

Lead manager Mark McAdam repurchased S&P 500 put options as part of an on-going hedging strategy. Mark adds that the put options should increase in value as market fear and uncertainty increases and the value of the S&P 500 drops. This will act as a bit of an insurance policy, helping to offset some of the potential downside in the fund should the U.S. market sell off.

In addition to the re-introduction of the hedging strategy, we added to our tech sector position during the July sell-off – increasing the overall exposure by 10.3%

Profits were captured in the Financial Sector, resulting in a reduction of exposure by 11.50%

That said, the overall exposure to Equities was reduced and exposure to Bonds and Cash was increased.

The cash raised in July through the reduction in the equity exposure has been earmarked to take advantage of quality companies that experience a sell off due to short term, temporary issues.

Mark notes that the Sharpe ratio of the income fund increased to 1.85 from 1.26 in July and continues to reflect a better long-term Sharpe ratio over its benchmark as does our equity growth fund. This observation suggest that we are managing risk efficiently.

Many investors focus on returns without considering the amount of risk a Portfolio Manager has taken to achieve their numbers. The Sharpe Ratio is a metric which tracks the average return per unit of volatility or total risk.

Typically, the higher the Sharpe Ratio value, the more attractive the risk-adjusted return.

TCG 539 Option Writing Fund

Our Option Writing Fund is designed to drive cash flow using income generating option strategies regardless of market direction.

The fund finished June positive with a 0.49% gain, however, it lagged its benchmark, the Montreal Exchange Covered Call Writers index which finished the month positive 1.64%.

As of the end of July, the Option Writing Fund sits at a 2.13% return for the year, while the MXCW currently sits at 3.29%

Lead manager Richard Croft notes that the fund remains balanced between value and momentum stocks and is 77% invested with 23% in cash held for new opportunities as well as cash equivalents.

As mentioned last month, the average duration of time until expiration for the option writes remains on shorter side at 33 days.

Richard adds that shorter term options are being written more specifically on the momentum stocks where the option premiums tend to be attractive due to the increased short-term volatility. With many of the value positions paying dividends, longer dated options typically results in longer holding times and the collection of dividends.

While Facebook and Netflix acted as a bit of a drag on performance for July, positions in Apple, Amazon and Google balanced out the impact with their positive performance.

Current Outlook and Expectations

Looking forward, we feel July’s sell off in the tech sector was a positive signal for the health of the overall market as Momentum stocks typically underperform in the first month after a market correction, such as the one we saw in February, followed by strength and overvaluation in the subsequent months.

Momentum taking a breather historically has been consistent with the development of a broader bullish trend.

Evidence of this comes from current year and fiscal 2019 market expectations.

Despite Netflix and Facebook disappointing, Better than expected results in most reporting companies has caused analysts to revise their earnings and sales forecasts upwards.  This indicates that companies are still growing and makes investing in stocks an attractive opportunity.

Looking out further, we are paying close attention to margins.  In both 2011 and 2015, peaks in margin estimates accurately predicted market tops.  Given the CAPEX (capital expenditure) cycle that is underway and the potential for trade risks to slow down revenue, margins are something we continue to watch closely.

Finally, strength in the USD will continue to weigh heavy on gold and oil which will act as an anchor for the broader Canadian economy.

 As always, we will continue evaluate and adjust as market conditions change.

July 2018 – Commentary & Outlook

Managing Through Uncertainty

The end of June marks the midway point of the year, and so far, it’s been quite a ride. Both the Canadian and U.S. markets logged modest returns, well off their respective lows of the year, but none the less underwhelming.

Markets never move in a straight line, and the path to these modest returns (0.40% for the TSX and 1.67% for the S&P 500) has been bumpy to say the least. The challenge for discretionary Portfolio Managers to this point in the year has been interpreting and managing the headline risks to protect investor assets, while capitalizing on the upswings.

Labour market numbers both in Canada and South of the border offered encouraging signs that economic growth should be sustainable, this, along with U.S. tax reforms should provide a tailwind, however geo-political friction and the ongoing trade “tantrum” continue to foster uncertainty.

The true impact from the most recent tariffs levied (and the new ones proposed) won’t manifest until the next round of corporate earnings in the third quarter. However, so far, the markets are moving higher with the anticipation of solid earnings and a resolution to global trade disputes.

As our CIO Richard Croft suggests, the trick is to manage through the uncertainty to benefit from a positive end game.

Fund Performance

TCG 531 Equity Growth Fund

The Equity Growth fund suffered a small loss in the month of June losing 0.34% while its benchmark, the TSX Total Return Index, was positive 1.69% led by strong returns in the Energy and Industrials sectors.

Lead manager Alex Brandolini comments that the Equity Pool was having a great 2nd quarter up until the end of June where concerns around trade wars shifted market sentiment causing the Equity Pool to register flat performance over the past three months.

Despite this most recent drag, the fund remains up 4.19% compared to the TSX TR at 1.95%.

Mr. Brandolini sites 4 key factors influencing fund performance:

  1. Trade wars
  2. Amazon effect
  3. Flattening yield curve
  4. Momentum interruption

 Trade Wars

Short term market events created a perfect storm within the fund since fears of a trade war hit two of the overweight sectors – Technology and Industrials.

The Amazon Effect

The Amazon effect hit one of the equity funds Health Care stocks as the online market place acquired an online pharmacy and investors expressed concerns around profit margins.

A Flattening Yield Curve

Bank stocks were also hit by a flattening yield curve as banks borrowing short term and lending long stand to face margin compression if this trend continues.

Momentum Interruption

By the end of the quarter, Momentum and Growth stocks acted as a drag on market performance while Value and Dividend stocks performed well as investors moved towards quality as trade tensions escalated.  Notable actions taken in the Equity Growth Fund included put writing on Momentum stocks to take advantage of higher implied volatility.

In addition, with an increased expectation for volatility, some cash that had been sitting on the sidelines was deployed into lower beta stocks. Stocks with a lower beta are less corelated with the broader markets and tend to maintain some stability during market declines.

We also took the opportunity to add to current Technology holdings on the most recent market pullback. Out-of-the-money covered call writes on some of these names were also implemented. This option strategy increases the yield on the position while maintaining the opportunity for significant upside in some of the top performing tech companies.

TCG 534 Income Fund

Our Income fund finished the month of June up 1.07% compared to the Real-World Index Income benchmark at 0.96%. Year to date the fund sits positive at 2.61% compared to it’s benchmark at 1.04%

In line with our expectations for a U.S. dollar pull back, lead manager Mark McAdam reduced the U.S. Dollar position and looked towards the options market to maintain exposure to U.S. equities while mitigating some of the currency risk.

As with the Equity Growth Fund, our Income Fund continues to benefit from market hypersensitivity and the volatility that comes with it.

Mr. McAdam has set aside approximately 8% of the funds cash for deployment during the upcoming earnings season. We will be patiently waiting to buy solid companies that experience a sell off due to a market overreaction to short term challenges, citing Oracle and Alibaba Group as examples. The stock will be purchased with a covered call strategy overlay to benefit from the depressed share price and expensive option market.

Mark also notes that our TLT strategy continues to generate a good return with modest risk. This strategy involves a combination of put writing and covered call writing around the iShares 20+ Year Treasury Bond ETF (TLT).  Option strike prices and expiration dates are selected based on our expectation on how U.S. Interest rate decisions will impact the bond market.

TCG 539 Option Writing Fund

Our Option Writing Fund is designed to drive cash flow using income generating option strategies regardless of market direction.

The fund finished June positive with a 0.54% gain, lagging the Montreal Exchange Covered Call Writers index which finished the month with a positive 1.77%. Year to date the Option Writing Fund and its benchmark are neck and neck coming in at 1.63% and 1.62% respectively.

Lead manager Richard Croft highlights that during the first quarter of 2018 we moved away from selling short term options with an average term to expiry of 21 days – to selling longer term options with an average expiration term of 55 days, to take advantage of higher volatility.  While this created a bit of a drag on performance in the first quarter, the strategy is paying off as the share class has rallied 4.34% through the second quarter of 2018.

Mr. Croft adds that the pool continues to follow a dual style mandate with about 50% of the portfolio holding Value stocks and another 45% falling into the Momentum camp. Most of the momentum plays are with the FAANG stocks (i.e. Facebook, Apple, Amazon, Netflix and Google) which have rallied sharply despite trade frictions.

We continue to maintain this strategy although we have lightened our exposure to longer term options as volatility contracts. Currently our average term to expiry is 41 days. We suspect this expiry spectrum will continue to contract unless volatility spikes because of a surprise in second quarter earnings or on the trade front.

 Current Outlook and Expectations

Given the short-term nature of recent news headlines and the fact that they came in quick and in a consecutive order, our long-term outlook has not changed as we believe the headwinds to the market will be resolved.

Our focus remains on: 

  • Trump’s objectives
  • Analyst expectations on Technology
  • Industrial sector oversold
  • Fed overtightening being unlikely

Trumps Objectives

While Trump’s tactics appear concerning to the markets, it is useful to evaluate what he wants.  We don’t think he’s interested in the tariff revenue because it is immaterial to running the U.S. economy.  Rather, we think Trump is seeking to end intellectual property rights violations taking place in China and he wants less barriers to entry into Chinese markets for foreign investment. It is conceivable that he’s using trade as a bargaining tactic. U.S. ambassadors have already come out and said they could abandon tariffs with European partners in exchange for trade concessions.  It is not much of a leap to think Trump is giving China the same message.

Analysts Expectations

Trade policy concerns are also not enough to overcome improving analyst optimism toward Q2 earnings results.

Expectations for S&P 500 EPS and sales in the quarter have risen 0.6% and 0.9%, respectively since the end of March.  Q2 EPS results are expected to rise 22% from a year earlier.  Technology stocks are expected to post a 25% year over year performance.

Technical Indicators

Technical indicators suggest the Industrials sector is overdue for a bounce as earnings season approaches.  It is the S&P 500’s worst performer since trade concerns broke out.  This sector is now testing support at its early-May low.  The 14-day Relative Strength Index (RSI) also indicates Industrials are more oversold than at any point since the sector’s February low.

With respect to the Momentum trade, growth dynamics haven’t reverted, and the underlying market and economic fundamentals support the idea that this has been a Momentum interruption rather than a material shift.

Fed Overtightening Unlikely

While the Fed (Federal Open Market Committee) has a mandate to control inflation, it is unlikely short-term interest rate will be increased at a rate that will derail growth.

Considering this, we expect that the markets will remain sensitive to the headlines and that market volatility is here to stay for now.

Our outlook remains positive and we will continue to take advantage the volatility by taking positions in companies we want to own on pull backs and capitalizing on increased option premiums resulting from the market uncertainty

As always, we will continue evaluate and adjust as market conditions change.


June 2018 – Commentary & Outlook

Sell in May?

Despite the old adage “sell in May and go away”, North American markets continue to climb a wall of worry with technology leading the charge.

Market volatility remains a consideration as headlines on trade, interest rates and political unrest and instability in Europe cause short-term swings.

These short-term swings have been an opportunity for us to capitalize on more expensive options premiums and to position our funds in companies we want to own trading at prices that we would consider to be a discount based on the underlying fundamentals. This approach of creating new positions on the lows and harvesting profits as stocks near short term highs has so far been productive for our portfolios.

Fund Performance

TCG 531 Equity Growth

May was a strong month for our Equity Growth fund putting in a positive return of 2.67% which was a little under the TSX Total Return bench mark. However, the year to date return comes in at 4.54%, well above the benchmark which sits at 0.25%.

When asked about how market conditions influenced the Equity growth fund, lead manager Alex Brandolini, confirms that market volatility during the month was inconsistent with underlying economic fundamentals. Market pullbacks in a strong economic environment normally indicate a buying opportunity. As such, one notable trade executed was a bullish put credit spread on SPY based on technical indicators suggesting the ETF that tracks the S&P 500 was oversold and ready for a bounce. This strategy generates cash flow as the ETF moves higher but has another option position built in as a hedge. The objective was to enhance the funds returns, but in a risk-managed way.
Alex added that with the market cycle continuing to mature, it was also decided to shift the funds exposure to companies with higher profitability and strong balance sheets. An example of our continued active management was the sale of our Disney position as the shares moved higher on the heels of its studio success, with the funds being allocated to the purchase of shares of Canadian Tire.  Alex notes that both companies operate in the consumer discretionary sector and share similar characteristics of high return on equity, low leverage and low earnings variability.

In general, and in line with the firms overall positioning, the fund remained overweight in the tech sector while trimming positions which had moved higher to harvest profits.

 TCG 534 Income

The Income Share class closed the month of May with a gain of 2.12% beating the Real-World Income Index benchmark which came in at 1.59%.  This brings the year to date return to 1.52% compared to the benchmark at 0.08%.

Consistent with our expectations and our overall approach, lead manager Mark McAdam notes that we continued to put cash in the Income fund to work on market pullbacks. We have been actively using a put writing strategy to take positions in companies that have been on our radar.

This approach was most recently used in May to take positions in BLK, MMC and STX at depressed prices while capitalizing on the high implied volatility of the options market. This strategy generates cash flow for the fund and lowers the cost basis of the shares as we take positions in the underlying stock.

In addition, part of an ongoing hedging strategy has been the purchase of put options on the S&P 500 ETF SPY as it approached short term highs.  Puts increase in value as the underlying security sells of and as implied volatility increases.  This helps offset some of the risk to the fund’s holdings associated with a broader market decline. This position was closed out profitably on a market pullback driven by headlines around Italy. A new position was reestablished as the S&P 500 approached it’s recent high.

The fund continues to be overweight equities with a covered call strategy overlay.  This is another approach used to generate cash flow as option premiums are attractive due to day to day volatility.

TCG 539 Option Writing Fund

The Option Writing Fund is managed to produce above- average cashflow through the selling of option contracts. Both bullish and bearish strategies may be deployed depending on market conditions

Not to be outdone, The Option Writing Share Class added 3.18%, ahead of its benchmark, the MX Covered Call Writers Index at 0.48%.

Year-to-date, the fund sits at 1.09% ahead of its benchmark which remains negative 0.14% for the year. To help offset some of the market volatility at the time, lead manager Richard Croft had been focused on selling longer dated options back in February to capitalize on the significant increase in implied volatility and to bring in more upfront cash.

With Option premiums having contracted in recent, Richard has been taking shorter term positions in the portfolio, especially in weekly close-to-the-money options. The typical approach as of late has been to sell close-to-the-money put options (options with strike prices close to where the stock is trading) and, if assigned to buy the stock, a one-week close-to-the-money covered call written on the purchased shares. This active strategy has been working well under current market conditions in helping to achieve the funds objective which is optimal cash flow.

Regarding sector concentration, for the past month the fund has been overweight in the tech sector mainly the FAANG stocks. The premiums are good, the option market is liquid, and the sector has been on firm ground as of late. The fund is underweighted the banks but may move back into that sector as the latest rate hike works its way through the economy.


Our general market expectations remain intact for the month of June.  Headlines continue to drive short-term market volatility, but this is seen more as an opportunity based on underlying fundamentals.  We will continue to build in hedges to offset a portion of the market risk.  We feel increasing interest rates are already factored in as a headwind to the markets and, overall, the economy is doing well. The wild card has been the imposition of tariffs and the risk of a trade war,  which has had the markets on it’s heels. The challenge is no one really knows how far this will go and how significant the impact may be. It is possible that this is another Trump bargaining tactic and we don’t believe that this will escalate to significant levels. That said, we will continue evaluate and adjust as market conditions change.

Q1 2018 Managers’ Commentary and Review

Applying Chaos Theory to the Financial Markets

President Trump likes chaos. Financial markets do not. Those facts became abundantly clear for the equity markets in general, and Amazon shareholders in particular, during the last week of March. As investors, the trick is to keep focus on the longer term while dodging the shorter-term darts hurled from a reckless twitter feed. To do that we need to have a rudimentary understanding about what makes President Trump tick.

On the surface it appears that we are dealing with a man who has a narcissistic personality disorder and is quite willing to engage in self-indulgent payback, even if it means slamming mega-companies like Amazon. In this case, the payback is aimed at Jeff Bezos, the billionaire president of Amazon.  Mr. Bezos just happens to own the Washington Post, which editorially has been one of the harshest critics of the Trump Presidency.

But Trump’s mastery of the get-even psyche only scratches the surface – and it may not be all bad because, underneath it all, Trump is not a politician. His outside voice has no filter and it aligns perfectly with his inside voice. That’s unique because most politicians’ outside and inside voices have never even had a first date.

We also know that Trump’s approach to negotiating is based on a stick and carrot approach. We have witnessed this throw-a-hand-grenade-into-a-room-and-walk-away-strategy play out in the US refusal to endorse the Trans Pacific Partnership (TPP), clashes with NATO about cost sharing arrangements, the tumultuous NAFTA negotiations and, more recently, pressuring North Korea to bend under the weight of sanctions.

The steel tariffs were the most recent volley in this chaotic approach to negotiating. The very notion of such tariffs was enough to send fearful shivers of an all-out trade war through financial markets. That doomsday scenario, however, was never a likely outcome because there is a vast chasm between Trump bluster and realpolitik economic reality.

Hence, the threatened imposition of large steel and aluminum tariffs is clearly a political move and there is no chance that an all-out trade war would ensue.

Trump gains nothing from a trade war especially if the other side targets his base. Notice I said Trump and not the US. Make no mistake – everything we have witnessed is about Trump and has little to do with American domestic interests. That’s important because with his personality, the President is not about to engage in a trade war that provides no political upside.

So why do this at all? In this case, the steel and aluminum tariffs were floated to prop up the chances that the Republican candidate would win a Congressional seat up for grabs in Pennsylvania (America’s steel capital).  More to the point, this Congressional seat is in a solid Republican District that Trump had won by more than 20 points during the previous election. With all the pomp and ceremony of a reality show Trump signed the Tariff order surrounded by steel workers at the White House.

The Democrats ultimately won that seat and, as for the 25% tariffs on steel and aluminum, almost every major trading partner except for China, which was always the primary target, has been granted an exemption effectively rendering the penalties moot.

China has already responded tit for tat with countervailing duties on pork and other agricultural products intended to apply maximum pressure on, you guessed it, States that form Trump’s base. But to me this is likely the opening salvos in trade negotiations that will begin in earnest later this year. The end game will see the US standing firm on the transfer of intellectual property with the quid pro quo likely to be more favorable treatment for Chinese imports. As both sides play to the gallery, likely causing additional volatility in the financial markets, the trick is wading through the mid-game.

There are positives to Trump’s approach. When he came into office he threatened to leave NATO. His rationale was that most of the NATO partners were not carrying their fair share of the costs. Within months the other NATO countries started upping their contributions. Clearly his threat worked.

With regards to NAFTA, frequent threats of cancellation have culminated with invocation of the “nuclear option” (whatever that may mean) with regards to Mexico and immigration.  Yet, at the same time, there is word of real progress and even an eagerness to conclude a deal – on the President’s own politically-shortened timelines.

He also got North Korea to the bargaining table – something that no other President has been able to do. In the lead up to negotiations with North Korea, Trump has maintained the maximum pressure campaign and for good measure appointed two hard line staffers (Bolton as the new National Security Advisor and Pompeo as Tillerson’s replacement for Secretary of State) to act as his supporting cast. I suspect Trump sees a successful North Korea summit as the best chance to turn around his numbers. Because of its importance he likely will get a favorable outcome, which could be good and bad.

Shorter-term, a clear victory would be a positive for the financial markets as it would provide stability in a region that is strategically and economically important. On the downside, it will support Trump’s position that his negotiating approach is spot-on, meaning we are likely to see more of the same in the coming months.

The challenge is to maintain a well-thought-out investment strategy that takes advantage of Trump’s bluster while managing the risk that his altered universe may become reality. Bluster creates buying opportunities in financial markets while an altered reality could traumatize global trade and investment values longer-term.

And there’s the rub! Weighing the probability of taking a simple long or short position based on potential outcomes that are Presidential-personality dependent is almost impossible. But if we enhance buy and sell decisions with options we can exponentially increase the chance of a positive outcome. At a minimum, we get paid to assume the additional risk.

To that point in the current environment many of our portfolios are benefiting from option contract premiums that are about double what we were collecting at the end of last year. Higher premiums provide cash flow for investors seeking tax advantaged income (option premiums are taxed as a capital gain in Canada) and provides a hedge against downside movements, which should benefit investors notably in the second and third quarter of 2018.

Think of this as our strategy to reduce the chaotic fallout from President Trump’s future “nuclear option” threats.

Richard N Croft
Portfolio Manager

 TCG534 Income Pool

In the first quarter of 2018 we increased equity exposure and reduced the allocation to preferred shares the Income Pool, resulting in a significant 24% shift in asset allocation. This shift was in response to the early February market sell off, which brought equities’ valuations back in line with reasonable levels, and to an 80% increase in implied volatility, which made equity option writing (selling) very attractive.

The pool’s overall equities allocation now over-weights the Information Technology and Financial Sectors. The Information Technology sector has strong fundamentals and free-cash-flow valuations are competitive. The Financial Sector is expected to experience EPS growth of 30% due to higher interest rates and improved credit performance.

As of January 1, 2018, we initiated a 5% annual distribution in the pool, paid monthly, which is funded by income derived from interest, dividends, and option premiums. To that end in Q1 2018 we employed the increased equities allocation in a covered call strategy, which capitalizes on the expensive option market and depressed equity prices.

To reduce volatility within the pool, we also increased allocation to gold through select resource companies. Gold typically exhibits a negative correlation to the overall equities market and acts as a hedge against equity risk. To increase cash flow in the pool and reduce the cost of hedging, we are also selling calls on the gold exposure, and we expect to maintain this strategy until the valuation of gold companies exceeds reasonable levels.

The correction and increased volatility during Q1 also provided us with an opportunity to unwind a hedge that we had put in place early in 2017. To address concerns of heightened equity valuations we purchased long-duration SPY (S&P 500 index) puts.   Since most of 2017 was a period of extraordinarily low volatility, these puts were trading at historic lows. After equity markets sold off and volatility spiked In the first week of February 2018, we sold these puts at a significant profit.

Mark McAdam, CFA
Portfolio Manager


TCG531 Equity Growth Pool

After an uncommonly comfortable and profitable 2017, Q1 2018 yielded the first US equity market correction since Donald Trump took office.  While most investors view such corrections negatively, in some ways we welcome the event as both a healthy adjustment and a new investment opportunity. Through January 2018, US markets got a bit ahead of themselves as tax reform materialized and price-earnings multiples became quite stretched.  While multiple expansion is a sign of a healthy economy, valuations must be reasonable if we are to continue to invest.

That’s not to say we were unprepared.  By design, the Equity Pool contains companies with favourable growth prospects, healthy balance sheets and stable price behavior, with which we aim to build and maintain a portfolio that will go down less when markets get rough.  So far in Q1 2018 we have been able to achieve this goal.

However, the volatility that returned to the market in February marked our entry into a new investment regime.  With US tax cuts behind us, many market participants lost their focus and investors started paying attention to other things such as uncertainty surrounding global trade.

Higher volatility also means opportunities to write (sell) options and collect greater premiums for bearing the risk of the underlying stock.  The question most people ask at this point is: if markets are getting riskier why continue to bear that risk and write options?  Fundamentally, it is because we are comfortable pricing that risk (with options) and we don’t think markets will drop much further in the near term.

While there are reasons to believe we are in the mature phase of the macroeconomic cycle, we probably still have a couple of more years to go. Unemployment is low and wage inflation is on the rise.  Further, tax cut savings are supporting a new business investment cycle.  Any money companies have left over is invested into employee compensation and share buyback programs, which are both good for markets and the economy.

Looking out to the rest of 2018, we see broadly-based sales and EPS growth across all sectors, which suggests that bottom-line earnings growth is moving beyond mere tax cuts and is now supported by top-line sales growth as well. While the recent era of steady growth with low volatility is unlikely to resume, we are optimistic about the year in general and stand ready with the necessary tools to navigate what comes ahead.

 Alex Brandolini, CFA
Portfolio Manager

 TCG539 Option Writing Pool
A Tale of Two Periods

Like the great Dickens novel, A Tale of Two Cities, it is both the best and worst of times for the Option Writing Pool, which experienced in Q1 2018 its first quarterly loss since it was launched in February 2016. The Option Writing Pool is designed to provide consistent, tax advantaged income to investors and as such now forms an important component of our new Enhanced mandates. The strategy is to manage risk within the pool by writing (selling) options that expire at different times, benefiting from the time value erosion.

The tale of most of the period since the pools inception was one of low market price volatility, which is the main variable in how options are priced. Higher volatility translates into higher premiums for longer periods – we get more when we sell the option – while a low volatility market has the opposite effect. In a low volatility scenario, the objective is to sell options close to maturity – sometimes within a week of their expiry – to benefit more frequently from the maximum decay of smaller premiums.  This best/worst scenario remained broadly in place through January 2018.

Times have changed since the beginning of the year, introducing us to the second financial market tale. Volatility has increased exponentially, which means this an excellent period for selling options as we are now getting much greater premiums for the options we sell.

In this scenario, as long as volatility remains above the historical norm we tend to sell longer-dated options because we can capture the higher volatility and the resulting higher premium. This works well for managing the income within the pool. However, due to the further out expiration date the time value of the larger premiums erodes at a much slower pace.  So, what we will likely experience through the second quarter is a slower uptick on the value of the pool, but at the same time we have banked significant capital to deliver the monthly income, which is critical to our investors.

Based on the current size of the pool we need approximately $2 million dollars to meet the monthly income requirement. We collect about $1.3 million from dividends on the stocks we hold in the portfolio while the remainder is delivered through the sale of call and put options. Altogether, we have already captured the additional cash flow from the sale of the options to meet our income needs. However, as mentioned, we will not likely see that benefit the pool’s price until the late second or early third quarter of this year.

Richard N Croft
Portfolio Manager

We’re Moving!

To support our continuing growth and serve you better, we are excited to announce that as of Monday,   October 23, 2017, R N Croft Financial Group is relocating to a professional and modern facility located close to the intersection of Highway 401 and the Don Valley Parkway in Toronto.  The move will take place on the prior weekend, with operations recommencing at the new location on Monday. Our contact phone numbers and e-mail addresses will remain the same.


R N Croft Financial Group Inc.
251 Consumers Road
Suite 801
Toronto, Ontario
M2J 4R3
Please reach out to Jason Ayres, Director of Business Development if you have questions on the move.


The Value of Good Advice

The following is an excerpt from our Q1 2017 Commentary and Review

In a recent CNBC interview, Warren Buffett made mention of the fact that investors were overpaying for advice. The thrust of his position was that investors were paying high fees, which penalized their portfolio, effectively preventing them from reaching their goals. His focus was on mutual fund fees and fees paid to hedge funds that were as high as 2% of assets plus a performance bonus of 20% for returns above a certain threshold. Being in the business of providing investment advice, these comments hit home from a couple of perspectives. On the one hand, I agree that mutual fund fees are too high. Investors with at least $100,000 in assets should probably graduate to separately managed accounts with transparent fees that scale down based on the size of the individual’s portfolio.

Secondly his comments on the fees associated with hedge funds were spot on. Investors who invest in hedge funds with a 2 and 20 fee schedule are grievously overpaying. The performance bonus alone provides significant advantages to the fund manager with virtually zero benefit to the unitholders. In fact, you could argue – which I have done in the past – that performance fees are a net negative to investors because they lead to risk taking that is rarely in the investor’s best interest. I think of the over-weighted losing position that Pershing Square Hedge Fund manager Bill Ackman took in Valeant Pharmaceuticals as a case in point.


Portfolio Diversifiers

I assume that all investors understand the value of diversification. It is all about developing a long-term portfolio strategy that will deliver performance within a tolerable level of risk.

Bonds are typically used as a portfolio diversifier. The fixed rate of interest delivers critical cash flow to the portfolio to offset the principal risk associated with equities. However, that fixed payout can cause fluctuations in the bonds’ price particularly in a rising rate cycle. When rates rise, the value of the bond declines and the longer the term to maturity the greater the impact that has on the price of the bond. In the current rising rate environment, bonds may be the highest risk asset in the portfolio.