A Note About Hedging

It is always a paramount concern of ours to protect capital along with generating growth. In situations like the one we have witnessed over the last few weeks the wisest course of action for a portfolio manager and investors alike is to not panic alongside the markets. A portfolio manager can make small adjustments to the portfolio to offset short term risks but the major decisions should already have been made. One should have a diverse selection of assets and be aware that markets go down much quicker than they go up. So, the psychological effect of a downturn is more profound than that of a gradual, rising market. With that said, patience is an asset as evidenced by the two-year return of over 10% in the Vertex Fund from 2008-2009. As of this spring, our confidence in the European solvency situation dissolved and we began re-positioning the strategies in the Vertex Fund and Vertex Growth Fund.

We generally use shorting as a hedging tactic for achieving returns through arbitrage or profiting from companies we deem in financial distress. However, as mentioned in recent commentaries we have been steadily increasing our hedging to offset market exposure in the portfolio. As a result, we entered July and August with a large amount of short positions and decreased general exposure to the market. This allowed the Vertex Fund to post a positive return for the month of July and enter the recent downturn with a reduced beta to the market. The following are some of the strategic changes we have made: Last week we hedged our silver call options using the SLV ETF in a way that exploits the current price volatility; we increased our exposure to gold through preferred shares in gold producers; we increased our allocation to merger arbitrage, especially with cash deals like Petrohawk; and we added more capital structure arbs like our continued short in Yellow Pages common shares that we have paired with a long position in Yellow Pages Preferred Shares that have a 22% yield paying out at year’s end.

As we’ve written about previously, one of the major themes in the portfolio is Apple and the companies affected by its success. We are comfortable continuing to hold Apple shares because of our shorts in companies like Nokia, Barnes and Noble, and Media General which are doomed in the new iPad/iPhone world.

2008 was a tough year that we took many lessons from. Much of the Vertex Fund’s down performance in the fall of 2008 was attributed to a few key positions that temporarily worked against us. We assumed that gold would be a safe haven during the crisis, it wasn’t, and we took losses in gold positions like New Gold warrants. This time we have hedged our exposure to New Gold and Kinross warrants using their common shares. Our large position in Athabasca Oil in 2008 (then a private company) got battered by rapidly falling crude prices and grey market mark-downs. This time the position is only 3.5% weight, a public company, and we have hedged its exposure dollar-for-dollar to a Canadian Oil & Gas Equities ETF. In this situation, we still pick up alpha from Athabasca when the market’s rebound.

There are currently few un-hedged, long-only positions in the portfolio which reflects of our present opinion of the market and where we see opportunities for generating returns during a volatile period. We expect the portfolio to be less volatile then the market with its current composition.

In the Growth Fund shorting is difficult to do, so we have been re-allocating the portfolio to a 75% weighting in preferred shares, long positions in the highest conviction M&A deals (cash offers), silver and gold. The remaining 25% will be in select companies we favour in the Vertex Fund. We see high conviction deals like Petrohawk Energy, TMX Group, Capital Power Income Fund and a few recent additions as the best way for making returns in an uncertain market.

until next time. . .

@The Vertex Team

For information on this update or the funds we offer, please contact your local sales representative:

Noel Dattrino
(Western Canada)

Michael Lindblad
(Central and Eastern Ontario)

James Wilson
(Central and Western Ontario, Maritime Canada)