Cowbell Please Ms.Yellen

More Cowbell Please Ms.Yellen

Arrow Capital Quarterly Commentary Quarter 3, 2013

By: James McGovern (CEO) & Mark Purdy (CIO) www.arrow-capital.com

Experience. Intelligent Investing.

hat a difference a quarter can make! On September 18th, FED Chairman Bernanke surprised markets by not following through on a well telegraphed reduction in QE. He Wleft everything on hold, the result of government fiscal battles and falling global economic activity. Unfortunately for Mr. Bernanke, he will not be around to see the QE experiment come to its denoument – but then again perhaps neither will Ms. Yellen. Naturally, my bet on Larry Summers as the next FED chair was proven wrong – hat tip to Robert Sanborn who told me shortly afterwards how wrong I would be on that call. Like all good prognosticators, I will try again but that won’t be for a long while now. I will say that “mistakes” by new FED Chairs generally occur early in their mandates – will see if Yellen continues that trend. One thing is sure, the “cowbell” will continue to be the musical instrument of choice.

Arrow Capital Management Inc. 36 Toronto Street, Suite 750 • Toronto, Ontario • Canada • M5C 2C5 • Tel: 416.323.0477 • Tel: 1.877.327.6048 • Fax: 416.323.3199 • www.arrow-capital.com 1 ARROW CAPITAL MANAGEMENT

The rally in UST 10 year yields CHART 1: U.S. FEDERAL GOVERNMENT BUDGET BALANCE* from roughly 3% to 2.5% is (% OF GDP) without a doubt predicated on the FED continuing its ultra aggressive easing policy. It strikes me that many market participants are simply not paying attention to Mr. Bernanke (or now Ms. Yellen). The $85bn in monthly purchases by the FED is hugely accommodative. As the chart beside shows, the US Federal budget deficit has been sub- stantially reduced – the result of the spending cuts/ revenue growth (see Chart 1).

Simple math then points to the FED buying more bonds monthly than the US government actually requires to fund itself. It is highly likely the future budget negotiations will yield further spending reductions, albeit modest. No wonder yields remain so low.

* Source: U.S. Congressional Budget Office (CBO) However, Deutsche Bank’s Alan Source: MRB Parners Inc., October 2013 Ruskin notes: “What the FED won’t tell you shows up in Q2 flow of funds.”1 He or end of tapering and QE, as many commentators notes that the issuance of UST’s was down to $299bn have noted, has likely been put off till Q2, 2014 at the from $1,186bn in Q2, 2012. However, while govern- earliest, especially given the upcoming Round 2 in ment issuance is falling, outside of the FED buying, the budget negotiations. The “taper tantrum” experi- most everyone else is selling. Foreigners did buy enced in Q2 will likely be back at some point in 2014. $89bn but that is way down from previous levels; but households (you and I) are selling ($190bn), The other big story in late Q3 and into Q4 was the deposit taking institutions ($100bn), brokers and never ending battle and brinksmanship between the dealers ($139bn) and money market funds ($19bn) Democrats and the Republicans on the debt ceiling. – that is a lot of selling the FED has to mop up to Putting aside the childish and dysfunctional behav- keep rates low! Of the roughly $12tn of federal debt iour of both sides, the outcome of kicking the debate outstanding, foreigners own $5.6tn, the FED owns can down the road a couple of months will allow the $1.9tn and the rest is owned by US domestic players. markets a temporary reprieve to focus on the fun- So what happens when the FED does finally end damentals. Given the backdrop of rate uncertainty, its tapering policy? When foreigners and domestic it is not surprising that US equities are well bid on players institutions figure out the only real bid is the the start of the rotation out of bonds. Investors FED, one cannot rule out a 1994 type move in rates continue to switch out of defensives (utilities and given the structure of the debt market. However, yield based equities) and into cyclical growth stocks. it is more likely that we have a grinding type of Economically speaking, the 3 horsemen powering the bear market for government bonds. The reduction US economy – housing, car sales and shale energy

CHART 2: END OF Q3 WOULD COST THE S&P500 INDEX AT LEAST 15% – remain highly sup- portive of 2014 US GDP growth in the 2.5 to 3.0% range. The continuing climb in the Yuan and China’s growing lack of com- petitiveness has also fostered a capex boom in the US. Not sur- prisingly, equities tied to these industr ies have done very well YTD. While this backdrop is favourable, it Source: Datastream, SG Cross Asset Research/Global Asset Allocation, Oct. 2013

is likely much of this CHART 3: U.S & SWISS EQUITIES MARKETS ARE THE MOST EXPENSIVE good news is already IN THE WORLD priced into the market. The three charts on this page courtesy of Societé Generale make the case that we are likely due for the cor- rection (you know the one that we all have been waiting for since 2009 with the market up 120% since!)

For stock pickers and long/short managers, there is good news in Red line = linear regression. Return of Equity = 12-month forward earnings/current book value Source: Datastream, SG Cross Asset Research/ Global Asset Allocation

CHART 4: CUMMULATIVE FLOWS INTO U.S EQUITIES

Cummulative net inflows into Equities funds (ETFs & Mutual Funds) since 2007. Souce: EPFR, SG Cross Asset Researché Global Asset Allocation Arrow Capital Management Inc. 36 Toronto Street, Suite 750 • Toronto, Ontario • Canada • M5C 2C5 • Tel: 416.323.0477 • Tel: 1.877.327.6048 • Fax: 416.323.3199 • www.arrow-capital.com 3 ARROW CAPITAL MANAGEMENT

CHART 5: CBOE SPX IMPLIED CORRELATION

Source: Bloomberg, Oct. 2013 that equity correlations have continued to trend lower (See Chart 5). Shorting has proven however bond and CDS spreads have tightened accordingly. to be difficult given the level of activist capital in However, as we have noted before, European banks play. Many market neutral managers we follow have are still reducing their massive leverage ratios putting already begun to shrink their gross exposures and a real damper on growth. The single currency dis- further diversify their short books to manage through tortions continue to generate a relative advantage takeover/activist risk of shorting failing companies. for Germany and the Netherlands over most other A recent story in Institutional Investor in a tongue and cheek way suggested that the best hedge fund strategy was “not to hedge” sub-strategy.2 Many allocators are now paying above market rates for hedge fund managers to manage long-only equity strategies.

With everyone overweight in US equities, is it time to turn our attention elsewhere? Looking at Europe first, the consensus seems to be that the economy has bottomed and is perhaps turning the corner. Money flows into European stocks have decid- edly picked up while corporate Deutsche Bank headquarters Deutsche Bank Twin Towers, Frankfurt Arrow Capital Management Inc. 36 Toronto Street, Suite 750 • Toronto, Ontario • Canada • M5C 2C5 • Tel: 416.323.0477 • Tel: 1.877.327.6048 • Fax: 416.323.3199 • www.arrow-capital.com 4 QUARTERLY LETTER - Q3, 2013

CHART 6: EURO NATION COMPARISON Japan, as we have noted before, bears close watching. In Q3, the Japanese government passed a hike in consumption taxes (from 5% to 8%) effective March 31, 2014. The initial eupho- ria surrounding Abe’s “2-2-2-2” policy has settled

2-2-2-2 Policy: Shinzō Abe’s proposed policy which he claimed would double Japan’s monetary base, its` own JGB holdings and aim for a 2 percent inflation rate within two years.

into a trading range for the Yen and the Nikkei 225. While demand will be pulled forward in Q1 2014, the 10 year JGB continues to fall in yield, which is not a good sign. Most commentators believe the consumption tax is a bad idea at this time costing some 1.7% to GDP3 thus adding to the deflationary trend. The government plans to offset this with a ¥ 5tn stimulus package. To accelerate nominal GDP growth, the BOJ will then have to do even more QE. We remain short yen vs. USD with a 110 target by next June. Japanese equities remain attractive as increasing Source: MRB Partners Inc., Oct. 2013

European nations – especially the Club Med coun- JAPAN WILL RAISE ITS SALES TAX TO 8% FROM 5% IN A BID TO CUT DEBT tries. With the Euro continuing to climb and the relative labour costs still favour- ing Germany et al. (See Chart 6), the situation remains far from certain in Spain and Italy. Without a true Euro banking union and the integration of fiscal policy across Europe, we favour both German equities and bunds over all else. With the German election going according to script, Ms. Merkel remains firmly in the driver seat with respect to any further European prog- ress or unification. Photograph of: Shinzō Abe (PM of Japan) Source: WSJ Oct. 2013 Arrow Capital Management Inc. 36 Toronto Street, Suite 750 • Toronto, Ontario • Canada • M5C 2C5 • Tel: 416.323.0477 • Tel: 1.877.327.6048 • Fax: 416.323.3199 • www.arrow-capital.com 5 ARROW CAPITAL MANAGEMENT

corporate restructurings/dividend increases, M&A account deficits it is unlikely 3% US GDP growth can and buy backs augur well for improving ROE’s and feed all the mouths. share prices (See Chart 7 below).

CHART 7: JAPANESE ROE’S AND SHARE PRICES

* Relative to global equity benchmark; local currency; rebased to January 1988 - 100; MSCI ** MSCI Source: MRB Partners, Oct. 2013

Like Europe, the Chinese economy appears to have CONCLUDING THOUGHTS stabilized with the addition of further government stimulus. This mild pick up, coupled with falling US With equity markets at 5-year highs and bond yields still yields, has led to an across the board bounce back historically low, investors are well served by holding in EM equities, currencies and bonds – especially some cash and waiting for better entry points. The back in those markets most impacted by rising rates drop for alternative strategies is good and perhaps the – namely current account deficit (fiscal & trade) past two years of sub par returns will be history once countries like Turkey, India and Indonesia. In our markets “normalize” i.e. get off the cowbell of central Q2 letter we highlighted longer term issues around bank, money printing. China’s slowing economy along with its highly levered economy (once shadow banking debt is All the best, included), rising nominal wage growth (squeez- ing corporate profits) and of course, a rising Yuan. None of these issues have been resolved, and like Europe, stability is good but the proof of growth and profits has yet to materialize. One thing is certain, with so many countries facing current Jim McGovern

SOURCES SECTOR EXPOSURES - AS AT SEPTEMBER 30, 2013

1. Deutsche Bank, Alpha Alert, Alan Ruskin, Sept. 26, 2013 ARROW DIVERSIFIED FUND (CLASS F)1 2. Stephen Taub, Institutional Investor’s Alpha, “What’s the Hottest Hedge Fund

Strategy? Not Hedging at All”, October 24, 2013 Long Short Net Gross Consumer 19.2% (7.5%) 11.7% 26.6% 3. Albert Edwards, Global Strategy Weekly, Societé Generale, October 3, 2013 Discretionary Consumer Staples 3.4% (2.3%) 1.1% 5.6%

Energy 15.9% (10.9%) 5.0% 26.8%

Financials 8.5% (4.8%) 3.7% 13.2%

Government 2.4% (2.1%) 0.3% 4.6%

Health Care 6.3% (2.4%) 3.9% 8.7%

Indices 4.5% (13.6%) (9.1%) 18.1%

Industrials 13.5% (7.5%) 6.0% 21.0% Information 20.2% (5.9%) 14.3% 26.1% Technology Materials 8.2% (4.5%) 3.7% 12.8% Tele-communication 3.0% (1.3%) 1.7% 4.3% Services Utilities 2.4% (2.4%) 0.1% 4.8%

TOTAL 107.5% (65.2%) 42.3% 172.6% 1 From January 2002, the returns are for Arrow Diversified Fund (Class F). All returns are net of all fees in Canadian dollars. This document is not to be construed as a public offering of securities in any jurisdiction in Canada. The offering of units of the Fund is made pursuant to the Offering Memorandum only to those investors in all jurisdictions of Canada who meet certain eligibility of minimum purchase requirements. Important information about Arrow Funds, including statement of each fund’s fundamental investment objective, is contained in their respective offering memorandum, a copy of which may be obtained from Arrow Capital Management Inc. Please read the applicable offering memorandum carefully before investing. Past returns are not necessarily indicative of future performance. The information and materials in this document are for informational purposes only. They are not intended as investment, financial or other advice. The information included in this document is not an offer to sell or a solicitation to buy any security nor does it constitute an offer by Arrow Capital Management Inc. to provide its investment advisory services in any jurisdiction in which, or to any person to whom, such would not be permitted under applicable law. While the information and material in this document are believed to be accurate at the time they are prepared, Arrow Capital Management Inc. cannot give any assurance that they are accurate, complete or current at all times.

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ARROW FUNDS Act II made a change in terms of their portfolio makeup by establishing a more diversified short book. The long book continued to outperform the Here are our quarterly updates through the third market but these gains were offset by the effects of quarter of 2013 for five funds on our platform. the rising markets on the specific short names. One Prices and performance reflect F-Class funds. of the big contributors in the quarter was a newly added position, Cisco Systems, which moved higher after a positive earnings report. It is currently the 1. Curvature Market Neutral Fund +4.9% through second largest position in the portfolio. September 2013. The Fund’s objective is to achieve above-average returns on a medium to long-term basis while pre- serving capital regardless of market conditions. Through comprehensive fundamental analysis using a bottom up approach, Act II looks to find opportunities mainly in consumer technology, media, telecommunications and entertainment companies all over the globe. One of the fund’s main advantage is their expertise in growth areas of the new digital economy such as internet services, online advertiser, smartphone and tablet manufacturers while discriminating against older or out of trend Curvature has maintained a positive return (1.1% technology. With a strong track record of deliver- for Q3) even as the broader markets and high beta ing consistent returns over 10 years of successfully names experienced major short squeezes through- managing this strategy, Act II looks to continue to out the third quarter. Optimal Payments was the focus on capital appreciation with moderate vol- top performing name out of the Fundamental Long atility and low correlation with equity markets. book while the Systematic Change strategy has been mixed with the markets’ choppiness as a result of uncertainty over the Federal Reserve’s decision 3. East Coast Investment Grade Fund +2.3% on tapering. Overall, the fund still generated positive performance even in an environment where through September 2013. many risk parameters are signaling an overbought market. As the third quarter closed, there has been renewed interest on the M&A front in Canada with a few arbitrage situations that seems attractive with a high probability of closing. Curvature’s event driven strategy hopes to participate in more of these attractive strategic deals in the energy space, especially in the oil and gas names.

Curvature is a market neutral strategy that focuses on North American small-mid cap equities. The fund is invested across three main strategies: system- Corporate issuance continued to be robust going atic, fundamental and event driven, which com- into Q3 as perception of eventual rising rates enticed plements each other to lower the fund’s volatil- companies to further lock in funding costs while they ity. The fund is slightly negatively correlated to are still low. Credit spreads were reasonably benign the market, and thus tends to be flat-to-pos¬itive as the supply was being digested. However, the sur- when the equities decline, providing down side pro- prise decision by the Federal Reserve to delay reduc- tection while underperforming when the markets tion in its asset purchases have somewhat eased rise sharply. Since inception, Curvature has pro - bond yields back off from its recent high. Given the vided consistent returns with less volatility than high level of activity in new issues, it’s all about the market. Managers James Hodgins and Geoff quality and not quantity, with many underperform- Phipps have over a decade of expe¬rience investing ing deals dominating the new issues market that in similar strategies for Ontario Teachers’ Pension were not attractive. The fund was up 1% for the third and Canaccord, where they worked together prior quarter, mostly driven from the core credit portfolio to forming Curvature. which experienced narrowing credit spreads as the fund carries no exposure to interest rate movement. East Coast remains somewhat cautious and continues 2. Act II U.S. Long/Short Fund +9.03% through to carry downside hedges in the systemic risk pro- September 2013. tection component in response to any fallout from the U.S. political landscape over the budget and debt ceiling discussions.

The East Coast IG fund provides enhanced credit exposure, on a tax advantaged basis, to an actively managed portfolio of primarily Canadian investment grade corporate and government bonds that are rated BBB- or higher. The team, led by Mike MacBain, with their extensive experience within the banking and financial services market in Canada, are uniquely

positioned to navigate the credit markets. The fund 5. SG U.S. Market Neutral Fund +2.4% through is designed to generate attractive risk-adjusted absolute returns and to preserve capital, while September 2013. seeking to eliminate the interest rate risk using proven hedging strategies. In addition, the fund also employs a macro overlay primarily to enhance returns and reduce volatility in times of uncertainty.

4. Raven Rock Income Fund +3.0% through September 2013.

Q3 started out strongly for SG as the fund generated alpha on both the long and short side in July. However, August turned out to be one of the roughest for the fund in a long time as geopolit- ical and rate hike risks dominated the headlines. As well, mismatches in the industry exposure such as high beta semi names being sold off, trans- portation stocks correcting with a rising oil price In September, the U.S. high yield market experi - and the building products sector weaker on rising enced a monthly record of new issuance at $52.7 short term yields. The win/loss record in analyzing billion, besting the previous mark set earlier in May earnings catalyst also fell short in August when this year. Even with this record issuance, the high a few names didn’t pan out as expected even as yield space held up relatively well which is an indi- the earnings outcome was accurately predicted. cation that there is still strong demand for yield. The fund ended up 70bps for the third quarter. The biggest event in the quarter was the Federal Looking forward, there will be a continual focus Reserve’s announcement that it will maintain its on improving the ability to manage risks in these rate of asset purchases, a decision that drove both volatile markets. As well, SG will be busy attending equity and Treasury bond prices higher. The reason many conferences and getting updates across mul- for the delay in taper stems from concerns about tiple industries which should position the fund well the budget and debt ceiling issues and the effects it going into Q4; traditionally the strongest perform- may have on the economy. In the third quarter, the ing quarter for the broader markets, as well as SG. fund was up 1.9%, driven from a strong convertible market due to its hybrid exposure to rising equity SG Capital invests in U.S. small-mid cap companies and bond prices though that part of the portfolio ($500M - $4B) using a market neutral approach. has been recently taken down as many convertible Combined with their bottom-up fundamental bonds are trading close to their fair value which research, they look to exploit the inefficiencies limits the opportunity to profitably put on convert- and lack of coverage in the mid cap space to iden- ible arbitrage trades. In terms of the outlook for tify profit opportunities that are different from high yield, Raven Rock remains constructive and market expectations. The fund tends to trade with will be on the lookout for good value in the space a short-term, active investing based around spe- on any potential pullback. cific company events such as earnings. SG will go long stocks that their analysis shows will have a The Raven Rock Income Fund invests strategically higher chance of beating consensus estimate, and between U.S. high yield and convertible bonds to short those that will likely miss consensus estimate. provide enhanced credit exposure to an actively The fund will often employ FLEX options, which are managed and well diversified portfolio. Taking customized equity or index options as hedges. SG advantage of the diverse and liquid $1.23 tril- Capital’s offshore equity market neutral strategy lion high yield and convertible market in the U.S. was ranked by Barclays’ database Top 10 Market (com¬pared to $28 billion in Canada), Raven Rock is Neutral funds for the period from July 2010 to June able to move easily and opportunistically between 2013. both types of securities. Managed by Nate Brown, Guy Caplan and Bobby Richardson, the team has worked together seamlessly since 1999 and have proven themselves through many types of market conditions. Through their extensive experience, they have pro¬duced attractive risk adjusted returns with typically low volatility as a result of utilizing hedging techniques which help mitigate the impact of market and interest rate risks.

Arrow Capital Management Inc. 36 Toronto Street, Suite 750 • Toronto, Ontario • Canada • M5C 2C5 • Tel: 416.323.0477 • Tel: 1.877.327.6048 • Fax: 416.323.3199 • www.arrow-capital.com 9