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Investing In The Unknown

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2016 was a year of volatility inducing events, which caused many markets to move in surprising ways on the back of results that separated themselves from popular consensus or polling. Brexit, the US election, a new OPEC narrative, and the US Fed raising rates were all tough on trends, inducing whips and reversals. Despite this, equities rallied while broad commodities had their first positive year in many.

Despite the irony of Trump's glitter, gold lost its luster, the U.S. dollar soared, and rates rose. This all came after oil rallied for most of the year, copper became king, and natural gas moved over 50% from its lows even though many called it a dead market. Notably, WTI rose 85% from its January lows while Canadian oil, the largest foreign supply barrel to the U.S., rallied from 15.76 to 38.59 (as per the Canadian Crude Index Reference Price), gaining 145%.

The stock market even remained unstoppable after an unlikely presidential candidate was elected to power. Canadian equities led the world, rising over 17% in 2016, which was the biggest increase since 2009, and the US market was on fire with the S&P500 gaining 9.5% on the year.

If the year has taught us anything, what stands out is being different and not following the pack in consensus or action. While typical "hedge funds", as ironic as that sounds, struggled, not all were negative. Our CTA and commodity investment strategies were positive, continuing to outperform at key times in 2016 when other CTAs underwhelmed expectations. We are very proud of this given how hard it was to achieve success in unforgiving market conditions. To be successful, it took character and resilience, along with agility and rock-solid risk management.

Looking forward, 2017 seems like a year that will be full of political risks and surprises. With elections coming in the Netherlands, France and Germany, and a clear lack of reliable polling, the populist movement is providing volatility from a seemingly unlikely place. Oil supplies are vulnerable to political risk, as production is concentrated in a small number of countries, many of which are unstable.

Domestic turmoil and conflict have disrupted supply from Nigeria, Libya and Venezuela in the last year, while the oil-producing Gulf States and Iran are politically and militarily tense. Moreover, with the approval of a pipeline to the west coast, for the first time in history, Canada has gained approval to move oil to tide waters and find new buyers in Asia instead of dumping 99% of its exports into the US. Essentially, the markets appear in for an unknown path.

So how do you capitalize on this? Maintain the course and stay disciplined. We think it is critical to be agnostic and remain tilted to the opportunities that the commodity and financial markets provide. While no one knows where the markets are headed, we will continue to simply be trend followers. This will be a year that starts with a bang due to an unbounded number of political narratives globally. Therefore, it will be important to separate capital allocation from risk allocation. If investors continue to focus on proper portfolio construction, the environment could be very profitable.

While portfolios are typically built by diversifying capital across different assets, this does not necessarily diversify risk. Often, we see seemingly diversified portfolios that are really just a concentrated bet on the equity markets due to their high correlation and volatility to these assets.

While these portfolios look diversified, even using typical alternatives such as infrastructure, real estate and private equity along with "hedge funds", they tend to be overweight on equity risk by 80-95%. In fact, most "alternatives" have a high correlation to equity, which is why one should really research potential holdings, especially in the new year where it will be important to do the right thing instead of the same or easy thing.

To really take advantage of the unknown, we suggest adding strategies with a low, or ideally, slightly negative correlation to equities. By our analysis, this is limited to currency, commodities, agriculture and CTA/managed future alternatives with the only negative correlation being the latter. It is only with these types of additions that one can reduce risk while still having the opportunity for gains if this seemingly unflappable equity market keeps rallying -- or just as likely -- fails and reverses.

All things come to an end. That's what 2016 really taught us, and that is all you really need to know for 2017.

Good luck.

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